THE250PERSONALFINANCE

QUESTIONSEVERYONESHOULDASK

PeterSander,M.B.A.

CONTENTSIntroduction

PARTIManagingMoney1PersonalFinanceBasics2BudgetingandManagingDailyExpenses3HowtoSaveMoney4ChoosingandUsingaBank5AboutDebtandCredit6MakingBigPurchases

PARTIIPlanningforLifetimeGoals7BuyingaHome8PlanningforCollege9PlanningforRetirement10AboutInvesting

PARTIIIKeepingtheShiponCourse:AvoidingFinancialSurprises

11ProtectingLifeandHealth12ProtectingProperly13ConcerningIncomeTaxes14YourFinancialLegacy

IndexofQuestions

AINTRODUCTION

s the“ought”decade (2000–2009)unfolds,people are confrontedwithevermorecriticalandevermorecomplexmanagementoftheirpersonalfinances. As people change jobs, financial guarantees like pensions

disappear.Asfinancialmarketsbecomemoreuncertain,ashomeprices,healthcare, and tuition costs skyrocket, and the complex tangle of tax laws evolves,there is more to worry about. Are the solutions simple and straightforward?Hardly. How much money will you need in five years? Twenty years? Tosupport a thirty-year retirement? To cover the possibilities of disability andunforeseenhealthproblems?

Most people can't figure outwhat theyneednextweekormonth, let alonetwenty years from now.Meeting today's needs andwants is so consuming oftheirtimeandmoneythatthereislittleleftoverfortomorrow.Therealityisthis:It takes considerable energy, foresight, discipline, contingencyplanning, and acertain amount of good fortune to make your finances work to achieve yourfuture goals. It requires a certain amount of professional skill to quantify andmanageyourpersonalfinances.

Manypeoplechoose to leave theprofessional skillpart toothers—financialadvisors,CPAs,stockbrokers, insuranceagents,and the like.While this“leavethe driving to us” model works for some, it is very dangerous in othercircumstances. Financial professionals have to make money, and the harshreality is that most make their money by selling something—insurance,securities,mutual funds,mortgages, and tax services.Canyouget acomplete,unbiased, and actionable financial strategy from these professionals? Yes,sometimes.Butinthesamewaythatithelpstoknowaboutcarsbeforetalkingto a car salesperson or that it helps to know about paint before talking to ahousepainter,so it followsthat italsohelps toknowsomethingaboutpersonalfinance before talking to a financial professional. Otherwise, you may getsomethingthatmeetstheirneedsmorethanyourownneeds,anditrapidlygoesdownhillfromthere.

So today's savvy shoppersgatherup informationbeforebuyinga car.Theyvisit manufacturer Web sites, automotive portals like Autobytel.com, KelleyBlueBook,CarandDriver,andsoforth.Theylookatpictures,features,prices,dealercosts,repairdata,andtestimonialsfromotherowners.Dotheseresources

makethedecision?Hardly.Butalongtheway,theycollectsomekeyfactsandimpressions. More importantly, they learn what questions to ask. They canseparate the jargonfromtherealities,and theyareable tounderstand thefactsandnumberswellenoughtodecide.

Whetheryouareanindividualortheheadofafamily,youarethechairmanandCEOofyourownfinancialdestiny.Regardingyourpersonalfinances,youmaychoosetodoitallyourself,delegateitalltoothers,orsomecombinationofthetwo.Regardless,you'llneedtoarmyourselfwiththebasics—thequestionsand at least some of the answers—to proceed. The 250 Personal FinanceQuestions Everyone Should Ask brings you a structured list of questions andanswers covering all aspects of personal financial planning. The questions aredesignedtohelpyoulearnimportantfactsandconceptsaboutpersonalfinance.Insomecases,theymaybeusedindirectconversationortodesignthequestionsyoumightaskofafinancialprofessional.Questionsrangefromthestrategicandconceptual “why” questions to the more tactical and precise “how” questionsaboutspecificfinancialtools.

The first group of these 250 questions covers personal finance as a broadtopic.Next is a large bodyof questions coveringdaily personal finances—themanagementofincome,spending,saving,budgeting,banking,andcredit.Fromthere, questions move to the more complex and subjective areas of financialplanning.Topicsincludetheachievementoffinancialgoalssuchascollegeandretirementand thesuccessfulbuildingofwealth toachieve thesedesiredends.The next set of questions covers external forces affecting the achievement ofthese goals—risk and taxes—that can sink your plans unless navigatedsuccessfully.Inthelastsetofquestions,thetopicofmanagingassetswhenyoucan't—estateplanning—isaddressed.

PART1

ManagingMoney

T

Chapter1

PERSONALFINANCEBASICS

he term “personal finance”makes the blood ofmany run cold. Uh-oh,hereitcomes.Toomuchmonthleftattheendofmymoney.Notenoughsaved for retirement or college. Eight thousand dollars of debt on my

creditcardandgrowing.Budgets.Saving.Taxrulessocomplicatedthateventheenforcersdon'tunderstandthem.Thestockmarket,thatemotionalbeastthatatesomanyforlunchin2000–03.Insurancepoliciesandcontractssocomplexthatyou hardly understand the reader-friendly version. Charts and graphs. Thecomplexmathematicalmysteriesofcompounding,makingmoneyworthmoreorless depending on time, an Einsteinian concept that might cause the geniushimselftoshakehisheadinconfusion.

The truth is, unless you were raised in a firmly financially conscioushousehold (and most of us weren't), most of the topics covered by personalfinance represent scary, unfamiliar territory. Dealing with finances is, in twoways, a date with the devil. First, formost it uncovers the consequences andscary realities of what happens when you don't have enoughmoney. Second,manyof thesolutions require thatdreadedconfrontationwith thebankofficer,insuranceagent,stockbroker,oraccountant,anencounterwhereyoustruggletokeep up with what they say and then somehow feel compelled to make adecisionafterlisteningtohalfanhourofincomprehensiblestuff.

Thischapter, containing the first10of the250questions, servesoneof themainobjectivesofthisbook:togetyoucomfortablewiththebasicelementsandphilosophyofpersonalfinanceandfinancialplanning.Withthisperspective, itshouldbecomeeasiertomoveforward.

Question1:Whatispersonalfinance?Boiled down, personal finance is nothingmore than themanagement of yourfinancial resources to meet your needs and achieve your desired goals. It ispersonal;thatis,it'saboutyou,yourfamily,andyourhousehold.Itisfinance;thatis,itconcernsmoney—thatwhichyouhave,thatwhichyouwillhave,andthatwhichyouneed.Itdoesnotconcernthings—thingsarewhatyoubuywithmoney.Itconcernshowmoneyisacquired,stored,andused.

Thehappyphrase“make it, spend it, keep it,grow it” summarizes the fourmajor quadrants of personal finance. Personal finance requires attention to allfour aspects in balance. Making money accomplishes little if it is spentfrivolously.Consumingmorethanoneproducesisnotviableinthelongterm.Ahousehold that makes and spends but doesn't save will achieve immediategratificationbutwill be caught short at somepoint in the future.Ahouseholdthat makes it, spends it, and manages to save some is on the right track butwithoutgrowingitmayfallshortofachievinggoals.

Personal finance involves planning both for today and for the future. Thetodaypart ismanagingcurrent income,expenses,andsavings.Planningcoversaspirationalgoalsandthemanywhat-ifsoflife.

ThequadrantmodelofpersonalfinancepopularizedbyRobertT.Kiyosaki'sRichDad,PoorDadseriesisagoodreference.ThefourquadrantsareIncome,Expenses,Assets,andLiabilities.ThedifferencebetweenIncomeandExpenses(netsavings)buildsAssets(good)orDebt(bad).ThedifferencebetweenAssetsand Liabilities is NetWorth, which, of course, is good if positive and bad ifnegative.

Personal financeessentiallycomesdown tomanaging the fourquadrantsofyourfinanciallife.

Question2:Whyispersonalfinancesoimportant?Life's goals—and themeans for achieving them—havebecomemore complexandatthesametimelessstable.Jobsandcareers,employeebenefits,andcostsof vital goods and services like homes, health care, and college education arechangingevermorerapidly.Financialmarketsarelesspredictable,andpensionsandevengovernmententitlements, likeSocialSecurity,are lessdependableaslong-term fallbacks. We are literally bombarded with promotions to buy orfinancesomethingeveryday.Thebottomline:Incomeandexpenseshaveboth

becomemorevolatilefortheaveragecitizen,andagainstthatbackdrop,peopleare living longer and have more ambitious aspirations. More carefulmanagementandplanningarenecessarytomakesureitallworksoutright.

Question3:Whatpersonalcharactertraitsarerequiredforfinancialsuccess?Granted,ittakesmorethancharactertraitstobefinanciallysuccessful—ittakeshard work, some degree of knowledge, and at least a little luck. Beyond thebasics, three character traits repeatedly emerge among financially successfulpeople:

1.Awareness.Togetwhereyou'regoing, thefirststep is toknowwhereyouare.Financiallyawarepeoplekeeptrackoftheircurrentfinances,includinghowmuchtheyget,whereitallgoes,andhowmuchtheyhave.Theytracktheimpactoflargeandsmallactionsintheirfinances.Theyknowhowmuchthey have in their pocket,what's on their credit cards,what's in the bank,what their investments are worth, and so forth. They know the importantparts of their financial plan, like their monthly budget, and how they aredoingagainstthem—nottothepenny,thatlevelofdetailisunnecessary,butwithinausefulballparkrange.

2.Commitment—the ability andwillingness to carry out the financial plan—followsawareness.Commitmentmustbeuniversalinhouseholds;itdoesn'tworkifonlyonefamilymemberisfinanciallyprudent.

3.Control.Control,inthissense,derivesfromcommitment.Itistheabilitytocontrol impulses, to make decisions with the big picture in mind, and toavoidtemptations.

Successful personal finance requires a combination of all three traits. Anyindividualorfamilystartingoutshouldfirsttakeinventoryofthesetraits,revisitthem once in a while, and put proper rewards in place to reinforce theirimportance.

Question4:Regardingourfinances,whatcanandwhatshouldwedoourselves?

Personal finance can be a skill-intensive and time-consuming activity Theanswertothisquestionreallydependsonyourownprioritiesandwillingnesstoinvest time to learnandplan finances.Mostpeople spendat least a fewhourseachweekmanaging routinehousehold incomeandexpenses.Theopportunityto outsource personal finance really enters with financial planning—that is,planningforcollege,retirement,taxes,andmanagingwealthtoachievegoals.

Whenremodelingahouse,anybodycanbea“do-it-yourselfer.”However,theprocessmay be time-consuming and frustrating, and the outcomemay not bewhat you had in mind—so you may decide to hire a contractor. Financialplanning presents a similar choice. Many people choose to outsource,recognizing the lossofcontroland (usually) increasedcost,but theymake thetradeoffconsciously.Stillmanymoreemployamix—some“do-it-yourself”andsome professionally managed, as with mutual funds. Unlike the remodelingproject,themixcanbeadjustedovertime.Butliketheremodelingproject,itcancost a lot to fix a bad job, and you as the owner must still take overallresponsibilityfortheproject.

Question5:WhereshouldI/wegetstarted?Formany,gettingstartedisoneofthetoughestassignments.Peoplegetusedtoacertain lifestyle. Then, confronted with the need (or desire) to improve theirfinances, theydread thenecessary lifestylechanges.Habitchangesandcontrolissues between family members create tension andmake it still harder to getstarted.

Experience proves it's best to startwith a clear assessment of your currentfinancialposition—income,expenses,assets,anddebt—almost likeacompanypreparingyear-end financial statements.Figureoutwhereyour incomegoes—thenature,frequency,andamountofeachexpense.It'sokay—actuallybetter—to group expenses into categories (e.g.,Miscellaneous Personal) than to trackdownevery$3.46spentforaStarbuckslatte.Thisthoroughexaminationofpastevents to determine cause is called financial forensics. Count all assets andliabilitiestodeterminenetworth,andmostofall,behonest.

The next step is to identify, quantify, and prioritize goals—things such asfuture home purchases, college education, retirement, vacations, and otheraspirations.Then(andpossiblywithprofessionalhelp)measurewhereyouaretoday toward achievement of those goals, and the process is under way.

Particularly for families, it works best if everybody works on this together,mainlytobuild theawareness,commitment,andcontrolrequiredtopull itoff.Periodic review meetings support the process, and with a little success andreward mixed in, these sessions become part of the family entertainmentrepertoire.

Question6:Whydopeoplefailfinancially,andhowcanitbeavoided?Thereasonsforfailurearemanyandvaried,butmostboildowntoalackofoneorseveralof the following traits:awareness,commitment,andcontrol.Simplywritingchecksorflashing theATMcardwithnoregard towhereyouarewillbust a plan—if therewas one in place to beginwith.Many people spend toomuch, enjoying a standard of living possible in the short term—though oftenonlywithinfusionsofdebt—butunsustainableinthelongterm.Theproblemisthat they haven't even stopped to think about the long term! They have noawareness, andwithout awareness, commitment and control are impossible. Itbecomesaviciouscycle;oncetheygetusedtothestandardofliving,thelong-termshortfallgetsbiggerandbigger.Theybecomemorereluctant to“face themusic,”andawareness,commitment,andcontrolarefurtherputoff,andsoon.

Question7:Whatshouldmynetworthbe?Networth—whatyouownminuswhatyouowe—istheprimaryfinancialenginedrivingtheachievementoffinancialgoalsand,ultimately,yourfuturestandardofliving.Why?Becauseasyougetolder,youproducelessincomebyworking,ultimately relying on income generated by your assets, plus governmententitlementslikeSocialSecurity,tolive.Obviously,yournetworthshouldbeashighaspossible,andthetrueamountofnetworthneededisgearedtoyourownpersonalgoalsandchosenlifestyle.

A useful and specific benchmark comes from researchers Thomas Stanleyand William Danko and their seminal work The Millionaire Next Door(Longstreet, 1996). Stanley and Danko found that average net worth for thehouseholds they researched was a function of income and age and that itamounted toaperson'sAge times theAnnual Income,alldividedby10.So ifyou're forty-five years old and have an annual income of $50,000, your net

worthshouldbe$225,000 [(45×$50,000)/10]. Ifyournetworth ismore thantwice this figure ($450,000), you are a Prodigious Accumulator of Wealth(PAW), and if your networth is less than half ($122,500), you are anUnder-accumulatorofWealth(UAW).

So get out your calculator, add up your assets and debts (including house,retirementplans, insurancepolicies,etc.),andfigureoutwhereyoustand!AreyouaPAW,UAW,orsomewhereinbetween?TheStanley/Dankobenchmarkisagoodplacetostartforsettingfinancialgoals.

Question8:I'veheardalotaboutthepowerofcompounding.InplainEnglish,whatisit,howdoesitwork,andwhyisitsoimportant?Compounding is the mathematical miracle adding so much to your financialpotentialifhandledproperly.Compoundingboilsdowntothis:Whenassetsearnareturn(interest,dividends,growth)andthatreturnisleftonthetable,notonlydotheoriginalassetscontinuetoearnreturn,butsodoesthereturn.Itisreturnonreturn,andas theyearsgoby, it is returnonreturnonreturn,andsoforth.The more the return—and the more time elapsed—the more impressive theresulting figure becomes. One dollar invested at 5 percent earns 5 cents(becoming $1.05) in one year, but earns $1.65 (becoming $2.65) if left fortwentyyears.

Thebasicformula:

FutureValue=Today'sValue×(1+RateofReturn)NumberofYears

Thefollowingtabletellshowmuch$1willbeworthwhenlefttocompoundfor different numbers of years and at different percentages of return.You cansee, forexample, that$1earning5percentperyear (asmentionedpreviously)resultsin$2.65intwentyyearsandthen$7.04afterfortyyears.

Thetablealsoshowshowgreatlyadifferentrateofreturncanaffecttheendresult. Increasing the 5 percent return up to 8 percent causes the forty-yearoutcometotriple,goingfrom$7.04allthewayto$21.72.(Youmayalsonoticethe astounding $7,523.16 that a yearly return of 25 percent produces in fortyyears.)

It should be obvious how important it is to leave assets in place to takeadvantageofthispower.Thatmeansdon'ttouchtheGoldenGooseand,ifatallpossible,don'ttouchtheeggs,either.Notonlyshouldyouleavetheassetsalone,butitisalsoimportanttomanagethereturn.Ashortfallofeven1percentor2percentcanmakeabigdifferenceoverthelongrun.Asaresult,returnreducerssuchasmutualfundmanagementfeesshouldbetakenseriously.

TimeValueofMoney:CalculatingFutureValue

Question9:Howdomypersonalfinanceneedschangewithage?Personal finance is all about planning for life stages, that is, the majoroccurrencesandphases inyour life.While long-termgoalsmay stayconstant,intermediategoalsandtheirprioritywillchange.Whenyoungandstartingout,the major objectives usually are buying a house, establishing assets andemergency reserves, and getting the compounding train rolling for retirement.Along the way, getting married and having children brings another set offinancialneeds—incomeandassetprotection(insurance),collegeeducation,andso forth. Eventually, your needs will shift to health care, long-term care, andretirement.

Question10:Howdoesinflationaffectmypersonalfinances?Inflationisoneofthosenagginguncertaintieswecan'tdoanythingabout,butit

bearswatchingclosely.Atitsroots,inflationmaynothaveanyrealeffectifyourincomeriseswithexpensesandyoumaintainyoursavingsplans.Assetreturnsalsowouldn'tbeaffected,forinterestrates,investmentpriceappreciation(drivenbysteadilyinflatingcorporateearnings),andhomeappreciationwouldkeepup.But unfortunately, inflation, particularly when out of control, doesn't affecteverything equally. Expensive supply inputs may not be passed on by allcorporations. Stagnant economic conditions resulting from price spikes in keyeconomicinputslikeoilmaycauseincomestonotkeepupwithinflation.Jobsmay go away altogether. If you have fixed sums invested in long-term fixedincome securities such as CDs, long-term Treasury bonds, etc., inflation willerodethebuyingpoweroftheseassets.Sotheprudentcourseistotrackinflationandparticularlythedistortionsitcausesintheeconomyandtoavoidowningtoomanyvulnerableassets.

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Chapter2

BUDGETINGANDMANAGINGDAILYEXPENSES

oomuchmonthleftat theendofyourmoney?Yourfirstresponsibility,astheoneinchargeofyourfinances,istogaincontrolofdailyexpenses.Withoutsuchcontrol,youarefarlesslikelytoaccumulatethenecessary

wealth to achieve financial objectives and improve your standard of living.Gainingcontrolusuallymeanssomeformofbudgeting.Whilebudgetinghasatediousandominoussoundtomost,itdoesn'treallyhavetobesohard.Itdoesn'thavetoinvolvetoomuchdetail,anditcanberevealingandevenfun.Readontofindouthow.

Question11:Ijustcan'tfigureoutwherethemoneygoes.WhereshouldIlookfirst?When it seems likeeverymonthshouldworkoutbut itdoesn't, it's time todosomefinancialforensics.Financialforensicsisthefirststeptocomingtogripswith your finances and building a plan. Really, it's a detailed investigation ofwhereeverythinggoes,whenandwhy.

Everybody's situation is different, but excess spending usually comes from(1) uncontrolled or impulse spending and (2) a failure to realize how muchthingscost.Impulsespendersbuyfirstandconsiderconsequenceslater—ifatall—andusuallyendupbuyingmorethanintended.Needapairofshoes?Resistthetemptationtoaddanewshirtandapairofslacksonimpulse,nomatterhowcheap or attractive. Buying groceries? Resist the temptation to buy unneededdesserts,magazines,andsnackfoods.Think“canIaffordit,anddoIreallyneed

it,anyway?”Rewardyourselffornotbuying.Many people fail to realize howmuch things cost. A weekend getaway is

nice, but despite today's low airfares, two tickets, a car rental,weekend hotel,meals,andasouvenirT-shirtaregoingtorun$800ormore.An$800weekendevery month or two will strain most budgets and deny precious long-termsavings.Evenadaytriptoabigcityoraneveningatabaseballgamecanrun$100, $200, or more without blinking an eye. Know the costs—all costs—ofwhatyoudobeforeyoustart.

Question12:Whatisbudgeting,andhowshouldI/weapproachit?Budgetingislayingoutaplanforincome,expenses,andthedifferencebetweenthetwo.Itstartswithfinancialforensicsandcontinuesbylayingoutasavingsandspendingplan.Thesavingsplanusuallyhastwocomponents:(1)off-the-topsavingscomeoutofincomebeforeithasachancetobespent(suchasfor401(k) plan contributions, emergency funds, and other savings pools) and (2)surplus savings put aside amounts of income left after expenses.Budgeting ismapping theexpenses,getting thecommitment,executing theplan throughthemonth,reviewingresults,andinformingandrewardingtheparticipants.

Question13:Whatarethemaincomponentsofafamilybudget?As long as it accomplishes the task, you can set upyourbudget anywayyouwant.Adaptedfromthisauthor'sPocketIdiot'sGuidetoLivingonaBudget,2ndEdition(Pearson,2005),herearethemajorpartsofabudget:

Gross Income is employer-paid wages or salary plus any regular orirregular income from any source. Tracking and projecting gross incomemustbedonewithspecialcareifyouareself-employed.

Net Income isGross Income less taxwithholdings, FICA, and formany,healthinsurancepremiumsandotheruncontrollableexpenses.

Off-the-top Savings are removed from income before becoming availablefor spending, like retirement plan contributions. The definition can beexpanded to include certain charitable contributions (like church tithing)

andcontingency“rainyday”fundstobesetaside.

Obligations aremajor and regular expenses tied to your chosen lifestyle.Many of these are contractual, such as home mortgages, rent, car loans,properly tax,anddaycare/school tuition.Obligationsmustbepaidbeforeconsideringotherexpenses.Note thatmanyarebilled irregularly, suchasproperly tax,andrequire funds tobesetasideeachmonth.This isoneofthebiggestbudgetingchallenges.

Necessitiesareimportantmustexpensestiedtoyourlifestyle,butthesecanbeadjusted throughmanagement.Groceries,utilities, telecommunications,school lunches, and homemaintenance are examples. If you have a tightmonth,youcanbuyfewerorcheapergroceries,uselesselectricity,orputoffthathomerepairproject.

Discretionary Expenses can be significantly modified or in some caseseliminated altogether. There are three subcategories of discretionaryexpenses:

PocketMoney is a set amount of “ATM”money each familymembergetsforroutineexpensesnotworthtrackingindividually.Pocketmoneymakes small purchases such as lunches, snacks, Starbucks, etc. Theamountshouldstayconstantfromweektoweekormonthtomonth. Family Allowance, or “FAL”, is a discretionary amount set aside forfamilyactivitiessuchasentertainment,eatingout,andsimilarexpenses.TheFALcanchangedependingonamonth'scircumstances.PersonalAllowance,or“PAL”,roundsouttheexpensecategoriesandisan amount for every family member to spend as they please withoutfurther tracking. It covers clothing, entertainment, books, hobbies, andotherdiscretionaryexpenses,anditcanchangeconsiderably.

Surplus Savings, the final component of the family budget, occur in thehappycircumstancethatthereissomemoneyleftoverafterexpenses.

Question14:DoI/weneedtotrackallexpenses?Simply, all expenses must be counted, but not tracked separately. Catchall

categories (see Question 13) such as Pocket Money, Family Allowance, andPersonalAllowancemake it unnecessary towritedowneverydonutor cupofcoffee.Doingitthiswaymakesthebudgetingprocessmucheasier.

Question15:Whatarethetwelvestepsofthebudgetingprocess?Again,ThePocket Idiot'sGuide toLiving on aBudget, 2ndEdition (Pearson,2005)givesaframework:

Understand income. Knowwhere income comes from,when and howregularly. Understand expenses. Financial forensics figures out where it goes,when,andhowmuch.Setgoals.Financialplanningdetermines long-termgoals,but therewillbe short-term budget goals too—a family vacation, $300/monthdiscretionaryexpensesforeachfamilymembertospend,oranewboat.Understandhabits.Asanoutcomeoffinancialforensics,understandhowyouandthefamilyhandlemoneyandcommunicate. Get savings and spending mechanisms in place. Establish savingsaccounts, retirement plans, direct deposit, and special credit cards tomanageindividualandfamilyallowances.Planincome.Buildadetailedplanforthenextmonthand,ifappropriate,thenexttwelvemonths. Plan obligations. Build a schedule of major regular and irregularunavoidableexpenses. Plan necessities. Estimate variable but necessary items like food andutilities. Be careful to make expenses reflect the time of year—as inhigherutilitycostsinmidsummerandmidwinter. Set aside pocket money. Does each family member need $40, $60, or$100 tomanage the little stuff through theweek?Decideon a numberandallowATMwithdrawalstothatamount. Plan family allowance. Set aside a certain amount for familyentertainment, home improvement projects, and so forth. For somefamilies,itisagoodideatohaveaseparatecreditcardforthesetobettertrackexpenses.

Planpersonalallowance.Establishanamounteachfamilymembercanspend,noquestionsasked.Again,adedicatedcreditcardmighthelp.Balanceandrebalance.Thisistheall-importanttwelfthstep.Ifthereisenoughincometomeetrequirements,perhapswithsomeleftover,you'redoinggreat!But formost families, there isn't enough togetby, so thisstepadjustsbudgetedexpensesandallowancestoarriveataviableplan.

Question16:Budgetingtakesdisciplineandcommitmentfromallfamilymembers.Howdowegetsuchcommitment?Withoutcommitment,budgetingdoesn'twork.Thesuccessformulawillvarybyfamily,buttwocommonmethodsaretoinvolveeverybodyinthebudget-settingprocessandtorewardperformance.Peopleinvolvedincreatingsomethingtendto support it, so budgets shouldn't be handed down from above. Rewards forgood performance—a generous holiday gift budget, a special vacation, or anend-of-year gift card from a favorite restaurant or retailer—always help.Keepingeverybodyinformedofprogresstowardgoalshelps,too.

Question17:Mustabudgetbewrittendown?Theshortanswer:no.Peoplestressoutoverthetimeandeffortrequiredtowritedownsomanynumbers.Somedon'twanttoberemindedofdifficultchoicesandtradeoffs. When starting out, it's important to write everything down to getfamiliar with the numbers and the outcome. But with experience the need towrite it all down may go away. Budgets for family allowance and personalallowancewillbecomesecondnature:youmighthave$300tospendeachmonthforyourPAL.Detailedmonthlybudgetcalculationandrecordingbecomesmoreimportantifincomeorexpenseschangealot.

Question18:Whydobudgetsfail,andhowcanfailurebeavoided?Mostbudgets,likemostofpersonalfinance,failifthereisalackofawareness,commitment,andcontrolamongallmembersofthefamily.Abudgetthatisnotfollowedor isstretchedwithabarrageofmonth-endexcuseswill fail.Once it

failsatimeortwo,it'shardtogeteveryonerestarted.Likewise,abudgetthatisfictioninthefirstplacebecauseincomeandexpensesaren'twellunderstoodwillalso fail. So, like many things in life, diligence, attentiveness, honesty andrewardedsuccesswillmakeitallright.

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Chapter3

HOWTOSAVEMONEY

avings are a much talked about but much neglected part of individualfinances. Indeed, personal savings—particularly ordinary, nonretirement,after-tax savings—have fallen to an all-time low, a fact that concerns

many economists. Why are savings so elusive, especially in today's reducedincometaxenvironment?Whyaresavingssoneglected,whenpeopleknowthatsomany important thingssuchasacollegeeducationaremore thanever theirresponsibility? Do people really not care about financial security? Do peoplereallyfeel theywillalwaysbeable toborrowtheirwayoutofproblems?Thischapterwillgiveyousomegoodwaystothinkabout—andbuild—savings.

Question19:Aresavingsreallyasingleiteminthefinancialplan,oraretheredifferenttypesofsavingstoconsider?A good financial plan segments savings into different categories for differentpurposes—anemergencyfund,long-termsavings,andshort-termsavings.

The“emergency”or“rainyday”fundisthefirstandmostimportantsavingscategory;it issetasideforincome-and/orexpense-relatedemergencieslikejobloss,unexpectedcarrepair,medicalexpenses,etc.Mostadvisorsconsideraboutsixmonthsworth of income adequate. These savings should be used only fortrue emergencies and should be kept in liquid form, that is, immediatelyaccessiblewithnopenaltyorcost.

Next on the list are long-term savings such as savings for retirement andcollege.Suchsavings,asimplied,aresockedawayforthelongtermandarenotto be touched but for the most dire circumstances. Regular contributions aregoodtokeepbuilding the“nestegg.”As thesesavingsare long-terminnatureandscope,theyshouldbeinvestedtoproducesomereturnandtotakeadvantage

ofcompounding.Finally—andlowestinpriority—areshort-termsavingsforsuchaspirational

goals as vacations or major purchases like cars, boats, and so forth. Moneyshouldbesetasideinothercategoriesfirst,andideallyeventhemoneyneededfor emergencies would come from this category before touching preciousemergency fund savings.Different investment vehicles are used depending onthe time horizon—short-term certificates of deposit (CDs) and credit unionaccountsoftenworkwell.

Question20:Whatarethebestwaystosavemoney?Saving money requires financial awareness and especially commitment andcontrol.Thebestwaytomakesavingshappenistohaveitpulledoffthetopofyourpaycheckbeforebeingavailableforotherpurposes.Directlydepositinganamountintooneormoresavingsaccountsworkswell.Likewise,retirementplancontributions (401[k], IRA, or similar plans) should be regular and automatic,andtheywillaccrueincometaxsavingsforeachmonththeyaretakenout.Assuchsavingsneverenterthehouseholdcheckbook;theydon'tgetrepurposedforotherthings.Afterawhile,theyaren'tevenmissed.Ifyoucan'tpullsavingsoffthetop,yourstandardoflivingisprobablytoohighforyourincome.

Buildinghomeequityisanotherpowerfulwaytoachievelong-termsavings.Aggressive mortgage payments, handled either as extra payments or throughregular forcedcontributionsusinga shorter fifteen-or ten-yearmortgage,workwell. The savings buildup accelerates over time as interest expense takes agradually smaller part of your payment. Sooner or later, you own your home,andyouwillhaveanicechunkofsavings.Peopleshouldat leastplanpayofftheir primary residence prior to retirement, and paying it off sooner makes iteasiertoreachothergoals.

Question21:HowmuchmoneydoI/weneedtosave?Thisisasimplequestionwithacomplexanswer.Thefirstpartistofigureoutwhatyouneed,eitherasingleamountora“lumpsum”capableofprovidinga“streamofincome”(likeapension)overtime.

Let's go for the more complex stream of income answer. Suppose youdetermine that you need $2,000/month for a twenty-year period in retirement.

Using the following table,youcancalculate adistributionannuity.This is theamountneededtosupportaconstantpaymentbasedonanassumedrateofreturnonsavings(assumedhereat5percent)retainedthroughtheperiod.

DistributionAnnuityTable

For twenty years at 6 percent, the factor is 11.5. Take the annual amountneeded($24,000)andmultiplyby12.5,giving$300,000.Thatistheamountthatyouneedtosaveovertwentyyearstoobtainthe$2,000/monthregularpayment.(Note that this amount doesn't include taxes—if the source of funds is aretirement account funded with tax-deferred income, you pay taxes on thewithdrawals.)

Now,toachieve$300,000insavings,whatdoyouneedtosaveeachyeartomake it happen? Enter the accumulation annuity, which works backward tofigureoutwhatneedstobesetasidetoachieveacertainsum.

AccumulationAnnuityTable

Suppose you have twenty years to accumulate the $300,000 and expect toearn the same 5 percent on your savings between now and then. Divide thisamount by the figure in the table for twenty years, 5 percent (33.1), giving$9,063 in savings needed per year, or $755 permonth. This is the amount tosave,startingtoday,toachievethe$2,000monthlypayoutstartingtwentyyearsfromnow.

If you play with these tables, you'll quickly see how the power ofcompoundingworksandhowmoretimeandhigherreturnsaccomplishsomuchmore. You can find more information on this topic in this author's TheEverything®PersonalFinanceBook(AdamsMedia,2003).

Question22:What'sagoodruleofthumbforhowmuchI/weshouldsaveeachmonth?Inanenvironmentoffrighteninglylowsavingsrates,hoveringaround1percentnationwide, this is an especially timely question. A good rule for mostindividualsandhouseholds,barringspecialcircumstances,istostrivetosave10percentofgross income.That is, ifyouearna$4,000permonthsalary, try toworkyoursavingsto$400permonth.Ifyoucansave10percentafteryour401(k) or retirement plan contribution, it is so much better. If you can save 10percentafteryourequityportionofamortgagepayment,that'sbetterstill.Inthisway,youbuildretirementsavingsandafter-taxsavingsforothergoals.

Question23:WhereshouldIputmysavings?This question really moves toward the topic of investing. The short answer:savings vehicles should be set up to match the savings objective. The keyvariables are liquidity and return. Liquidity refers to the ease of penalty-freeaccess to the funds; return refers to what you earn on the money. Higherliquiditymeans lower returnsandviceversa.Other factors include trust in thefinancialinstitutionandconvenience.

Emergencyor rainydayfundsarebestkept in liquidsavingsformssuchasbank or credit union accounts with easy transfer to the household checkingaccount. Long-term savings should be invested in securities—stocks, bonds,mutual funds, etc.—and usually should be held in specially set-up retirementplansor inbrokerageaccounts.Short-termsavingsdependonthetimehorizonandmaybeamixofliquidinvestments.

Question24:Iwanttobecomeamillionaire.Isthatarealisticgoal?HowdoIpullitoff?Theshortansweris“yes,youcandoit.”AsThomasStanleyandWilliamDankoso clearly demonstrated in The Millionaire Next Door (Longstreet, 1996),incomehelps,but the realkey is financialdisciplineandstability.Millionairesare likely to bepeoplewhoworkedhard—butwho also stayedput, droveoldcars, and in general, resisted the temptation to consume and especially thetemptationtoshowoff.Withthepowerofcompounding,peoplewhochoosetopersistently livebelowtheirmeans,keep their standardof living incheck,andprioritizesavingscanmakeitevenonordinaryincomes.

B

Chapter4

CHOOSINGANDUSINGABANK

anks, credit unions, and similar institutions are a fundamental andnecessarysteptowardachievingyourfinancialobjectives.Theyprovideservices vital to day-to-day money management and, increasingly,

services helpful for long-term financial planning.Banks are big, scary, and, ifnotusedwisely,canbeexpensiveand frustrating toworkwith.The followingquestions offer a few things to look for—and avoid—in choosing and using abank.

Question25:Areallbanksthesame?Whyorwhynot?First of all, there are different types of banks.Full-service banks usually have“bank”inthename—BankofAmerica,FirstInterstateBank,orCitibank.Theymay be large and national or small and local, but they offer a wide range ofservicesforconsumersandlocalbusinesses,includingchecking,savings,andafull assortmentof loanandcredit services.Manyaregettingmore involved infinancial planning, insurance, and investments as regulatory restrictions ease.Savingsandloans(S&Ls)aretraditionallymoreconsumerfocusedanddoalotofmortgagebusiness,but theyaremoving towardbecomingmore full-servicefinancial institutions (WashingtonMutual, forexample).Finally,creditunions,which are nonprofit and usually have select memberships, offer many full-servicebankingservicesatalowercost.

Due to relaxed regulation and mergers and consolidations, there has beensomeconvergenceamongthetypesofinstitutionsjustdescribed.Banks,S&Ls,andcredit unions look increasingly similar.However, the subtledifferences intheirservicesandthequalityofservicemeritcarefulconsideration.

Question26:Bigbankorsmallbank?Whichisbetter?Bigbankshavegottenbigger,andlikemostofcorporateAmerica,theyareveryfocusedondeliveringshort-termprofitstotheirinvestors,oftenattheexpenseofcustomer service. Unless you bring an exceptional amount of business (i.e.,money),you'llbejustanumber.Intoday'sbankingworldthatmightnotbeallbad,however.Bigbankshavemanybranchofficesacrossawiderangeofstates,and you can get banking services—and free ATM withdrawals—just aboutwhereveryougo.Biggerbanksaremorelikelytooffer“24/7”bankingserviceand Internet-based banking—although don't be fooled, these offerings are notjust for your benefit, as they lower the bank's costs, too. In today's world of(mostly)electronicbankingthroughATMs,phones,andtheInternet,bigbanksjustmight be okay.But if you have complex banking issues—in particular, ifyouhavesmallbusinessbankingneeds—smalllocalorregionalbanksmightbebettersuitedtoyourneeds.

Question27:WhatkindsofbankingserviceswillIneed?Today's households almost certainly need a checking account, and theconvenience of a checking account “debit” card is becoming increasinglyattractive. Likewise, free and accessible ATM services are essential for cashaccess. Some form of savings vehicle to accumulate off-the-top savings (seeChapter3)fromdepositedincomeisimportant,asis“directdeposit”tocapturethisincomeinthefirstplace.Roundingouttheessentialspictureissomeformofoverdraftprotection,inordertoavoidhighfeesandexposurefromaccidentallyoverdrawingyourcheckingaccount.

Other services run the gamut from loans and safely deposit boxes to fullfinancial planning services, insurance, investments, collegeplanning, and evenautomatedbankingandpaymentservices.Somepeoplelikethe“one-stopshop”approachtomanagingtheirfinances,whileotherswilldothelegworktogotodifferent places: banks for day-to-day banking and specialists for financialplanning services. It's a tradeoff based on the quality and convenience ofservices locally available, but be sure to properly assess this quality—and thecost—oftheseservicesbeforechoosing.Banks,whileofferingeverything,maynotofferthebestservicesorthebestdeal,andtheyoftenuseinsuranceandloanservicestosubsidizetraditionalday-to-daybankingoperations.

Question28:WhichbankshouldIchooseandwhy?The “fast, friendly, and effective” model for choosing most products andservicescertainlyappliestochoosingabank.First,forthe“effective”part,youshould look forabankoffering the rightbalanceof servicesat the rightprice.Look closely at checking account fees (and the required balances needed toavoidthem)andfeesforservicessuchasoverdraftprotection,“roaming”ATMuse, excessive transactions, and balance inquiries. Examine rates of returnofferedonsavingsand,insomecases,checkingaccounts,althoughthisusuallyisn't a major deciding factor—you're looking for money management, notinvestingreturn.

Next is the “fast” part.Does the institution have convenient locationswithconvenienthours?ConvenienthourshavebecomelessimportantasmorepeoplebankwithATMs,by telephone,andon theInternet. (Checking thequalityandcostofthelattertwomethodsisworthwhile.)

Finally, the“friendly”part is still important.Does thebank treatyou likeacustomer? Do bank officers and telephone customer service agents treat youwithrespect?Aretheyflexible?This ishardtoknowinadvance,but typicallythe smaller the institution, the better. Of course, local word-of-mouthassessmentsareimportant.

Question29:Howmanycheckingaccountsshouldwehave?Householdbudgetstendtofunctionmoresmoothlyifthereisasinglehouseholdcheckingaccount intowhichall income isdepositedandoutofwhichallbillsandmonthlyexpensesarepaid.Itissimplyeasiertokeeptrack,andsincemostchecking accounts cost money for checks and processing fees, it is cheaper.Personalspendingbyindividualfamilymembersisusuallybettermanagedusingcash pocketmoney and a personal credit card. There are exceptions: separatechecking accountsmake sense for children away at college, for example. Forthose in their late teens and adults with their own earned income, separatechecking accounts are a good financial learning exercise and probably makefamilyexpensecontroleasier.

Question30:Whatarethebiggestbankingmistakestoavoid?

Usedcarefullyandproperly,bankservicesarecleanandrelativelyfreeofcost.Banksmakesomemoneylendingyourdepositstoothersathigherrates.Butforsmall depositors and people who mainly use checking services, banks reallymake their money on fees. Fees start with monthly checking fees and checkprinting and escalate rapidly into overdraft charges, overdraft protection fees,stop-payment services, and so forth. The $2 your bank charges for a foreignbankATMwithdrawalplusthe$1.50theoriginatingbankchargesisaheftybiteoutof the$20youput intoyourpocket.Moral:avoidsuchspecialized“safelynet” services. Manage your finances to avoid overdrafts and plan ATMwithdrawals in advance. Don't feel obliged to use a bank's major credit card(VISA, MasterCard). Typically such cards are more expensive and burdenedwith higher fees.Likewise, their loans and other servicesmay not be the bestdeal.

Question31:I'veheardalotaboutonlinebanking.Whatisit,andisitrightforme?Online banking is still in its early adoption phase. Customers particularlyadaptedtodoingthingsonlineareusingit,butithasn'thitthemainstream.Ithasthe compelling capability to put everything in front of you, allowing minortransactionswithaclickofamouse—includingpayingbills—saving timeandmaking it easier to track your finances. But today it is still burdened withexcessivefees,especiallygiventhatthebanksavesmoneyonitsoperations(byavoiding manual check processing, for instance). Not every bill can be paidonline.Finally,timespentloggingoncanbeanuisance,especiallycomparedtoa simple trip to the checkbook. Nevertheless, online banking probably is thefuture.Onewouldexpecttopaymoresomedayfortraditionalbankingserviceswith online banking, ATM debit cards, cell phone wireless banking, etc., toreplacethem.

F

Chapter5

ABOUTDEBTANDCREDIT

or better or for worse, debt is the high-octane fuel powering today'seconomy and the finances ofmost individuals. The advent of consumercredit and the debt resulting from its use is a relatively modern

phenomenonemerging in theearly twentiethcentury.Thecomingofuniversalnational credit cards and networks likeVisa andMasterCardmade the use ofcreditmorepopularandfarmoreconvenientthanpayingwithcash.Todaymostretail transactions use some from of plastic, and most other major purchases,suchascarsorhomes,aremadewithsomeformofdebt.Likeanyhigh-octanefuel,creditanddebtcangetyouintotroubleifusedimproperly.Readontolearnhowtousethispowerfultoolwithoutgettingburned.

Question32:Whatisthedifferencebetweendebtandcredit,andwhyisitsoimportant?Peoplegetthesetwotermsconfusedallthetime.Debtisanamountyoualreadyowe someone, to be paid offwith interestwithin a specific time period.Debtrepresentsmoneyalreadyspent,tobepaidbackwithdollarsearnedinthefuture.Credit, on the other hand, represents the potential to borrow money to buysomething.Credit reflects financial strength anddiscipline—theability to pay.Thus, credit is a good thing, and debt—most debt, anyway—is a bad thing.Many people get this confused.You shouldwork to reduce debt and improvecredit. Note: this doesn't mean acquiring more credit cards, but insteadimprovingyourcreditscore.Foranexplanationofwhatthatentails,readon.

Question33:Myrichaunttellsmealldebtisbad,butI'mstillnotsure.Istheresuchathingasgooddebt?It'sprobablyokaytoassumethatalldebtis“bad”andthatthelessdebtyouhavethebetteryourfinancialfooting.Withthatsaid,somedebtusedforsomethingscan be “good,” that is, beneficial to your long-term finances. For example, amortgage used to acquire a home (1) provides a place to live and (2) allowsownership of a solid asset historically likely to grow in value.An educationalloan can boost your career. Even short-term “opportunistic” debt used to buysomethingyouneed at a bargainprice canbe “good”debt, likeusing a creditcard tobuy futureholidaygiftsduringanAugust sale.Somedebt is justplainnecessary—toreplaceabrokencar,fixaroof,etc.Nowcomesthe“baddebt”—debt incurred to support excessive spendingbeyondyour standardof livingordebtthatexceedsyourabilitytopayitoffquickly.

Question34:Howdopeoplefallintothedebttrap?Howdoesoneavoidit?There are lots of possible reasons for becomingoverextendedwithdebt.Mostboil down to poor spending habits, unforeseen expenses, or poor creditmanagement.Poorspendinghabitsincludeimpulsebuying,livingbeyondone'smeans,and

strivingto“keepupwiththeJoneses.”Unforeseenexpensescanbebrokendowninto trulyunpredictableexpenses—carrepairsorreplacingthe lawnmower—orthose that are predictable but nobody predicted them, such as that semiannualinsurance bill that somehow didn't make it into the spending plan. In eitherinstance, failure toplan and lackof emergencyor “rainyday” fundswill landthese expenses solidly into the debt column. Finally,poor creditmanagementhabits—minimal payments and too many credit cards—will deepen the debtcyclealreadyunderway.

Thebottomline:livingbeyondone'smeansandhavingalackofawareness,commitment, and control will roll the debt snowball downhill at an alarmingpace.

Question35:Whatdifferenttypesofcreditareavailable?

Mostconsumersknowaboutcreditcards,butithelpstorecognizeotherformsofconsumerdebtandhowtousethemproperly.

Revolving credit allows borrowing up to a predetermined limit for anundefined period of time with a minimum but otherwise undefinedpayment. Old debt is replaced by new debt through new charges orpurchaseseachperiod,thustheterm“revolving.”Oncecommonlyofferedbyindividualmerchants,creditcardsarenowtheprimaryexample.

Installment loans aremade for a fixed amount andhave a fixedpaymentovera fixed timeusuallyata fixed interest rate.Theyusuallycomefromspecial finance companies for large purchases; car loans are a goodexample.

Mortgageloansarelong-termloansforthespecificpurposeofbuyingrealestate, which in turn secures the loan. Since failure to pay results inforeclosure, transferring the asset to the lender, the lender can afford toofferlowerinterestrates.

Equity lines combine the best features of mortgage loans and revolvingcredit. The asset secures the loan, giving interest rates far lower thanunsecured revolvingcredit.Timeperiodsaredefinedbutusuallyare longterm (five to ten years), and payments are indefinite. Interest is usuallyincometaxdeductible.Thedanger:theseloansaresoattractiveandeasytouse that they tempt people into borrowing and putting their house on thelineforbaddebt.

Question36:WhatisacreditscoreandhowdoIgetone?Whyisitimportant?A credit score is a single number used in the lending industry essentially tomeasureyourreliabilityandabilitytopaydebts.AcomplexmodeldevelopedbyFair, Isaac & Co (“FICO Score”) assesses your creditworthiness from yourpaymenthistory,amountofincome,currentandpotentialdebt,andemployment.

Scores are furnished on a 300–850 scalewhere 850 represents near-perfectcredit and 300 is totally uncreditworthy Scores below 500, representing thelowest1percentof thepopulation,areprojected tohavean87percentdefault

rate. Forty-nine percent fall between700–799,with a 2 to 5 percent projecteddelinquencyrate.Yourownscoreisavailablefor$12.95atwww.myfico.com.

Creditscoresareobviouslyimportantforlenderstodetermineif,howmuch,and at what rate to lend youmoney. People with low scores will pay higherinterestrates,getsmallerloans,orwillbedeniedcreditaltogether.Interestinglyand controversially, credit scores are sometimes used as a general characterassessment for insurance and employment qualification. The bottom line:keepingthisscorehighbymanagingcreditwellisagoodidea.

Question37:HowcanIimprovemycreditrating?Maintaining reasonableamountsofdebtandpayingbillson timeare themainways to keep your score high. Late or nonpayments hurt more than anythingelse.Beyond that, evidenceof stability throughemployment,homeownership,orlong-termrentingallhelp.

If you have a poor score, the first step is to get a credit report throughMyFICO (www.myfico.com) or from any of the three major credit agencies(Experian, Equifax, orTransUnion). The report doesn't just show the score; itshowsallknownloansandcreditcards,paymenthistory,andmissedpayments.Mistakescanunnecessarilyharmyourscore;suchmistakesshouldbetakenupwiththelender.Startgooddebthabitsimmediatelybypayingontimeorearly.

Beyond payments, other factors such as excessive balances, balances at ornearcreditlimits,andtoomuchshiftingbetweenaccountswillhurtyourrating.Car, student, and other types of loans all count. Toomuch credit, even if notused,willhurtyourscore.LendersareskepticalifyouhavedrawersfullofVisa,AMEX,andothercreditcards;thepotentialistheretogetintotrouble.Cancelthecreditcardsyoudon'tneed.Thebottomline:usecreditmodestlyandwisely.

Question38:IfIswitchtoanothercreditcard,willthatadverselyaffectmycreditrating?Theanswerdependsonyourcreditprofileandwhyyou'reswitching.Ifyouhavealongcredithistory,payoffbalancesregularly,andseldomapplyforcredit,itispretty much a nonevent. However, if you move balances frequently or haverecentlyappliedforcreditelsewhere,itwilllikelyaffectyourcreditscore,albeittemporarily.Ifyou'reswitchingaccountstotrytostretchoutpaymentsorlower

theinterestrateonanexcessivebalance,thecredit-scoringagencieswillnotice.Butmostpeoplefindtheneedtochangecreditcardseverynowandthen—dueto amove, amore attractive offer, better customer service, etc. If your credithistoryisotherwiseacceptable,theconsequencesshouldbeminimal.

Question39:Whatisthedifferencebetweendebitandcreditcards?Whiletheylooksimilar,theyareverydifferent.Adebitcardisreallyameanstopayelectronicallywithwhateverfundsyouhaveinthelinkedaccount.Adebitcard transfers funds immediately and electronically from your account to thepayee's.With acredit card, a financial intermediary (usually abank)pays thepayee immediately, while you pay the bank back at a later date. Debit cardspending is limited to your on-hand balance, while credit card spending islimitedonlybyyourcreditlimit.

Thedebitcardmaysay“Visa”or“MasterCard”onit,butthatonlybroadensacceptance and allows access topayment systems, not the credit provisionsofthecardsupplier.

Debit cards are gradually overtaking checks and cash because they aresimplerandalmostuniversallyaccepted.Theywillnotworkforrentingcars,forthere is no other binding promise to pay for excess use, damage, etc., as isimpliedby the credit limit on a credit card.Thedownsideofdebit cards: it isharder to track expenses. There is no equivalent to a check register (exceptmonthlystatementsoronlinesummaries),anditisalmosttooeasytowhipoutthedebitcardandforgetaboutit.

Question40:Whatdifferentkindsofcreditcardsarethere?Therearemanywaystoclassifycreditcards.Forthisanswer,itmakessensetodescribemajorcreditcards,“charge”cards,andspecialtycards.Major credit cards include the common Visa, MasterCard, and Discover,

usuallyissuedbyorthroughmajorbanks.Thereareseveralspecialtypes:

Gold and Platinum credit cards have some preferential services (likeproductwarrantyandotherkindsofprotectiveservices)andconveysomedegreeofstatusbutusuallycostmore(higherfees,interest).

Rewardcreditcardsreturnsomeformofincentiveforuse—airlinemileageorevenaportionofyourpurchases incash.Mileagecardsareubiquitousandusuallycostalittlemore,butfrequentuserslikebusinesstravelerscanaccumulatealargesumofmilesessentiallyfree.TheDiscovercardis theprime example of the cash reward card, refunding up to 1 percent ofpurchases.While interest ratesarehigh, therearenoothercosts,and it isreally a hidden gem among cards especially if you pay off balancesmonthly.

Affiliatecreditcards,likeGMMasterCardorL.L.BeanVisa,offerproductdiscountsandcertainotherbenefits from theaffiliated supplier.Someareconnectedtocharitablecauses.

Charge cards look andwork like credit cards but require balances to bepaidoffmonthly;thatis, thereisnocreditextended.AmericanExpressistheprimeexample,offeringmanyspecializedservicesalbeitatafairlyhighcost.

Specialty credit cards are issued by single businesses such as departmentstoresandoilcompanies.Thesecardscanbehandyforspecialbudgetitemsor to take advantageof special sales, butmostof these companies acceptthemajorcreditcards,too.Sogiventhatitiseasiertokeeptrackofcreditusewithfewercardsandthatyourcreditscorewilllikelyimprove,itisbesttominimizeuseofthesecards.

Question41:Rewardcardssoundlikeagoodidea,butwhatarethepitfalls?Rewardcardsallowyoutobuildupmileagepoints,discounts,orevencash.Butthe downside usually is higher credit costs.Most reward cards have relativelyhighinterestratesandannualmembershipfees.Theever-popularChaseUnitedMileagePlusVisa carries a 14.99percent interest rate (in late 2004) for goodcustomersanda$60annualfee;fromothercardoffers, it ispossible toget10percentinterestratesandnoannualfees.Soisitworthit?Ifyouspend$500amonth on the credit card, you'll get 6,000 flyermiles per year—roughly one-quarter of an airline round-trip (at 25,000 miles for a U.S. round-trip coachticket). If youvalue that ticket above$240, one-quarter of it pays for the $60

annual fee, assumingyoupayoff your balance.But if youonly spend$200 amonthornevertravel,itprobablyisn'tworthit.Discoverstilloffersthenotableexception: 14.54percent interest rates andno annual fee and a 1 percent cashreward, which ismoney that can be used anywhere. The bottom line: chooseyourrewardscarefully,dosomemath tomakesure they“pencilout,”andpayoffyourbalanceeachmonth.

Question42:WhatcreditcardsshouldIcarry?To a degree, the answer is a matter of personal preference; “whatever worksbest” is really the right answer. One good approach is to allow each familymember (over eighteen) a major credit card for their personal allowance (seeChapter2).Thiscanbeanormal,areward,oranaffiliatecreditcard; it reallydoesn't matter. Family expenses can be kept on yet another joint credit card.Discoverworkswellforthis,forthe1percentrebatescantakesomeofthebiteoutofexpensivehome improvements, family travel, andso forth.Finally,youmaywant tohave ahandful—thoughnot toomany—of specialty credit cards.Formostfamilies,itishardtokeeptrackofmorethantwoorthreebalances,sotheneedforanycreditcardsbeyondthatnumberneedstobecarefullyjustified.

Question43:HowdoIchooseacreditcard?Choosinga credit card is similar to anythingelse; examine thecosts, features,andbenefitsandthendecide.Keycreditcardcostsincludeannualfees,interestrates (relevant only if you don't plan to pay off balances monthly), and latepayment fees. There are other fees for exceeding credit limits, but hopefullythese will be irrelevant for you. Features and benefits include the obviousrewards and affiliate benefits. But there are alsomore subtle items: length ofgraceperiod(theperiodbetweenstatementcloseandpaymentdue)andeventhegeographiclocationofthecreditcardissuer.PaymentsmailedtoDelawarefromtheWestCoasttakeawhilewitherraticdelivery,creatingopportunitiesforlatepayments and fees. The basis used to calculate interest is important. Is it theaveragedailybalanceorsomethingelse?Customerserviceisalsoafactor.Aretheagentsaccommodatingandwillingtogiveyouslackifyou'relateonceinawhile?Thereisnowaytotellforsurefromthecreditcardoffer;wordofmouthisagoodresource.Don'tbefooledintothinkingthatanaffiliatecreditcardtied

to a companywith excellent servicemeansyougetgreat serviceon the creditcard;thesecardsareusuallyrunbybigbankswithfewrealtiestotheaffiliate.

Question44:WhatismyfinancialresponsibilityifIloseacreditcard?Bylaw,yourfinancialliabilityislimitedto:

Nothingafteryoureportthelostcreditcardtotheissuingcompany$50 foranyfraudulentcharges incurredbefore the loss is reported(andmanyissuerswillwaiveeventhisamount)Nothingifyoustillhavethecardbutthenumberwasusedfraudulently,thatis,inamailorInternettransaction

These protections are reassuring. In addition, credit card issuers employhighlysophisticatedauditmodelstoferretoutpotentiallyboguscharges.IfyouliveinArizonaandtypicallycharge$200amonthforsmallpurchases,a$5,000moneyorderpurchasedinIowawillmeritaverifyingphonecallfromtheissuer.You'rewellservedtotakethatcallandresolvethematterquicklybutdon'toffertoo much information to the caller, such as your complete Social Securitynumber.There have been scams around this type of call.While there is someprotection,it'sinyourbestinteresttocarryaminimalnumberofcreditcardsandkeeptrackofchargesyourself.Don'tbuycreditcardlossprotectioninsurance,asyouprobablydon'tneedit.

Question45:Whyisidentitytheftsoimportant,andhowdoIguardagainstit?Identify theft has always been a problem, but it has escalated substantially inrecentyearsaselectroniccommercehasgrownmorepervasiveandfar-flung.Ithas become easier to obtain a person's identify, more lucrative to use itfraudulently, and harder to catch the culprits. With a bogus identity, anyoneanywhere in theworld can set up a charge account, purchasing anything fromanywherewithlittlerealchanceofgettingcaught.Onceyourcompleteidentitygetsoutthere,itcanbeboughtandsoldfurther.

Identity theftgoesbeyondstealing thecarbonsofyourcredit card from thetrash.Whileacertainamountoffraudcanbeperpetratedwiththisinformation,it is really your complete identity and especially your Social Security numberthatshouldbeguardedatallcosts.Acompleteten-digitSocialSecuritynumber,address,birthdate,andalittlefamilyhistorywillallowcriminalstocloneyouatwill.Theupshot:youshouldn'tcarryyourSSNonyourperson,norshouldyougive itout toanyonecontactingyou,byphoneoron theInternet.Onlygive itout when absolutely needed and when you initiate the contact. Watch yourincomingandoutgoingmail, andmail sensitivedocuments, like tax returns,atpostofficesorinpublicmailboxesifyouhavereasontobesuspicious.IfyourstateusesyourSSNasadriver'slicensenumber,askforadifferentnumber.

The Federal Trade Commission offers a handy Web site discussing thenature,prevention,andresolutionofidentitytheftatwww.consumer.gov/idtheft.It'sworthyourtimetotakeatripthroughtheWebsitetobecomefamiliarwiththistopic.

Question46:Mywallet/pursewasstolen.Whathappensnow?The first step is to list to the extent possiblewhatwas contained in the item:whichcreditcards,formsofidentification,andfinancialdocuments.Considerallforms of such documents—passports, personal checks, pay stubs, and bankstatements, for instance. Contact credit card companies immediately. This notonlyavoidsthe$50liabilityexplainedinQuestion44,butalsoalertscompaniestoyoursituationandbeginstheprocessofgettingthisinformationbacktocreditbureausandagencies.Next,ifpersonalchecksorbankstatementsareinvolved,notifyyourbank.Youwillneedanewcheckingaccountandaccountnumber.It'salsoagoodideatonotifythemajorcreditbureaus—Equifax,Experian,andTransUnion—directly (see theFederalTradeCommissionWeb sitementionedinQuestion45 to findouthow).Thenyou'llneed toquickly reportapassportloss to theDepartment of State and renew your driver's licensewith the statemotorvehiclebureau.

Whilelosingawalletorapurseisanuisance,mostinstitutionsaresetuptohandle this sort of situation and generally do it with relative ease andexpedience. The bank portion is the most difficult and stressful hurdle,particularly if you have outstanding but unpaid checks, which the bank mayseem towant to do little about.But you shouldbeup and running financially

withinoneweekor so,while bearing little in thewayof financial cost. If thesituation is urgent—for example, if you are traveling—credit card issuers andlocallawenforcementagencieswillhelpyougetwhatyouneedintheformofidentificationandcredittocompleteyourtravel.

Again, the Federal Trade Commission identity theft Web site atwww.consumer.gov/idtheftisanexcellentresource.

Question47:ShouldIpayoffcreditcardseachmonth?Inaword,yes.Monthlypaymentinfullisasignthatyourfinancesarehealthyandthatyourconsumptionismatchedtoyourincome.Italsosavesinterestandpreserves credit to borrow when you really need something. Sharp personalfinanciersuse timepaymentsonly if theysavea loton thepurchase,aswithapostseasonclothingsaleorsimilarpurchase.

Question48:Whataretherealandhiddencostsofcredit?Firstofall,credit cost is reallydebtcost, anadditionalcostof spendingmorethanyouhave.Theobviouscostsare the interestpaid to fund thedebt,whichcanoftenbe21percentperyear.Annualfeesandchargescanbe$80percardfor thefanciermajorcards.Thoseare theobviouscosts; lessobviouscostsarelate payment charges (averaging about $30 andgoing up to $40), interest rateincreasestriggeredbyanylatepaymentonyourcreditrecord,andcashadvancefees($5upto2percentof thebalanceadvanced,plus interest fromthedayofwithdrawal).Evenlessobviousisthehigherinterestrateonotherfutureloansifyouhaveoverextendedcredit.Thebestcredithabits (no-feecards,on-time in-full payment eachmonth, no cash advances) keep the cost of credit relativelylowandmaybeatzero.Butpoorhabitscancosthundredsofdollarseachyearpercard.

Question49:Whatis“APR”?APR stands forAnnualized Percentage Rate. You'll see loans quoted at a 7.5percent nominal rate and an APR of 7.79 percent. What does that mean? Itmeans there are additional loan charges—a credit report, an annual fee—thatmust,bylaw,becalculatedintotheAPR.APRallowsclear“apples-to-apples”

comparisonbetweenloans.

Question50:Ingeneral,howshouldIusecreditcards?Prudentindividualsusecreditcardsprimarilyasaconvenientmeansofpayment,that is, as an alternative to cash or checks. It is simply easier, andmonth-endsummariesmake it easier to track expenses.Whenused strictly as ameansofpayment, bills are paid in full each month. But there are situations whereextended credit can make sense to capture a special low price on somethingneededanyway.Saving20percentormoreusuallyjustifiestheinterestexpense,ifitisplannedcarefullyandpaidoffquickly.Creditcardsareusuallythetooltohandle emergencies, such as an unexpected car repair. Use of credit cards tofundbaddebtortoaccumulateairlinemilesisthewrongway.

Question51:Howdomostpeoplegetintotroublewithcreditcards?Therootcauseofcreditcardtroubleisspendingtoomuch.Butpoorhabitsandmanagementofcreditbalancescanmaketheproblemmuchworse.

Makingminimumpaymentsortoosmallapaymentisusuallythefirsterror.Aminimumpaymentof$20ona$1,000balancelooksattractive,butitwilltaketenyearstopayitoff.Thetotalinterestpaidoverthattime,at21.5percent, is$1,548.Ifyoupay$50eachmonth,itonlytakestwoyearstopayitoff,andthetotalinterestcostwouldbe$248.

Gettingtoomanycreditcardsorchasinglower interestratesbytransferringbalancesfromcardtocardoftenendsupintrouble,too.Thetemptationtolowerinterest rates is good in a way, for it lowers credit expense and allows fasterpayoffs.Butmanypeoplebecome too focusedon therate—not thebalance—andsomehowbaddebt starts tobecomeacceptablebecause the interest rate isonly9.9percent.Whentransferringbalances, it ishardtoreallystopusingtheoldcard,andsoonmultiplebalancesproliferateonmultiplecards.

Consolidatingcreditcardbalancestoanothercardortoahomeequitylineisanother trap. Wiping the slate clean across the many credit cards seemsattractive,buttheusualrealityisthatbalancescreepbackontothecleancards.Youmustthenservicethosebalancesandalargeconsolidatedbalance,too.

Question52:PeopletellmethatasecondmortgageorhomeequitylineisagoodwaytocarrydebtorrestructurethedebtIhave.Isthisright,andwhataretheadvantagesanddisadvantages?Therearetwoinherentadvantagesofusinghomeequityfinancingtopayoff,orrefinance, other debt. First, interest costs are lower, often by as much as 15percent;second,interestisusuallytaxdeductible.Butthelistofdisadvantagesislong.Firstandmostobvious:youareputtingyourhomeontheline.Thisisabigdeal.Second,those“clean”creditcardbalancesarelikelytoreappear,negatingthe advantage. Third, interest rates are variable and fairly sensitive to theeconomicenvironment,andyour interestcostsmaygrowand, inanycase,areunpredictable.Finally, youuse upgood credit that really shouldbe applied tootherlong-termpurposes,ifatall—bigpurchases,emergencyuse,andsoforth.Soyou're better off focusingon eliminating thedebt or avoiding it altogether.Resistthetemptationtousethisattractiveformoffinancingtomaskpoordebthabits.

Question53:Igethitseveraltimesaday,oftenbytelemarketers,withproposalstocashouthomeequitythroughrefinancing.Whendoesthismakesense?With2004interestratesatanall-timelowandhomeappreciationatanearall-timehigh,itseemstomakesensetocashoutatleastsomeportionofequity.Butlike most investment decisions, you must decide if there are other betterinvestments.Inthiscase,youareincurringaninterestcostandtakingonmoreriskof losing theproperly.Sogenerally itmakes sense ifused to remodel thehome(thusaddingvalue)orforsomeotherexpensethatwillproducelong-termreturns (such as education to build a career). Using home equity to financecollegeeducationforchildrencanbeokay,butotherformsofcollegefinancingshould also be examined. Using home equity to finance retirement should beusedasa last resort.Cashingout to invest in thestockmarket shouldbedoneonlywithgreatcare.Youmustachieveareturngreater thaninterestpaid,plussomepremiumtocompensate for therisk taken.Theremaybeanexception ifthehomeisyouronlyassetandyouaretryingtodiversify.Clearly,cashingouttosupportunnecessaryshort-termspendingisano-no.

Question54:Ihavea$30,000balanceonmyGoldMasterCard.WhatshouldIdo?First of all, you're not alone. While the average household credit card andinstallmentdebtrunsabout$9,000,manypeoplefindthemselves insuchabighole.There aremanyways toget there—job loss, frequent job-relatedmoves,expensesforstartingabusiness,orjustplainnegligent,out-of-controlspending.

Thefirststepistostopspendingnow.Putthecreditcardinadrawer.Next,youshouldreviewthe interest rateand lookfora lowerone if itmakessense.Paying18percentmeans$5,400/year in interestcost—areductioneven to10percentwouldsave$2,400/year.Whileinmostsituationsit'swisertofocusonthebalanceratherthanontheinterestrate,herethenumbersarelargeenough—costly enough—to move to a lower rate if possible. That lower rate may befoundwithahomeequitylineifyouhaveoneavailable,butcaremustbetakennottojeopardizeyourhomeownershipandtoavoidgettingdeeperintodebt.

Once you determine where to carry the debt, you must carefully budget apaymentscheduletopayitdown.Theplanshouldtakethepaymentoffthetop,thatis,beforeotherspending.Spendingwillusuallyhavetobecut.Itcanhelptoget a quick income boost somewhere else through a second or part-time job.When set aside, that income can service the debt and then provide a financialrewardwhenfinallypaidoff.

Alongthewayyoushoulddoafinancialforensicinvestigationtodeterminewhy you got into the situation the first place.With the right combination ofawareness,commitment,andcontrolmostpeopleemergeokayandwithagoodfinanciallessonundertheirbelts.

B

Chapter6

MAKINGBIGPURCHASES

ig purchases are purchases of the sometimes inevitable, sometimes merelydesirablethingsthatmakelifegoon—orgoonwithmorepleasure.Carsarethe quintessential big-ticket item. You need a car, and most people can't

simply write a check to buy one. Other big purchases range from homeappliances, furnaces, and other necessities to such pleasures as big-screentelevisions, boats, andnewpatio furniture.Regardless of thepurchase, carefulplanning is important. Without the kind of planning described below, thesepurchasesbecomebudgetbustersanddeadweightinthewayofpayingmonthlyexpensesandachievingothermoreimportantfinancialobjectives.

Question55:Ingeneral,what'sthebestwaytoplanforbig-ticketpurchases?The bestway is to build a savings component into your budget and set asidefundsoffthetopofyourincome.Thesefundscanbeseparatedintoadifferentaccount or remain a designated portion of your primary savings account. Theneed and timing of the purchase doesn't always allow saving in advance, sopurchasingoncreditisokayifcarefullyplanned.Calculatethemonthlypaymentandputitinthebudget.Creditpurchasesarebestusedtotakeadvantageofabigpricebreak;theoverallpurchasecostwillbelowerevenincludingthecostofthecredit.Butdon'toveruse this rationale; savingwith saleprices is abad idea ifyou end up over your head. Finally, you must look at the long-term cost ofownership,notjustthepurchaseprice.Itisacommontrap,forexample,forboatbuyers to overlook the cost ofmaintenance, storage,mooring, insurance, fuel,etc.

Question56:IthinkIneedanewcar.WhatalternativesshouldIthinkabout?Buyingacar isa frustratingandemotionalexperience thatcan really setbackyour finances.Yet, sooner or later, nearly all have to endure this pain.Whilechallenging, thebestadvice is tokeepcoolanduseas rationalanapproachaspossible.

Thefirstquestion:doyoureallyneedanewcar?Ifyoucleanand/orfixtheoldone,willitdothejob?A$1,500repairisonerousbutmaybecheaperthandepreciation on a new car. In many states, such an amount is less than thetransaction costs—sales tax, registration fees, and difference in insurancepremiums—involved in buying a new car. Do the math and you might besurprised.Finally,beforedoinganything,spend$25onagoodfull-servicecarwash;youmightbesurprisedathowmuchmoreyoulikeyourcurrentcarwhenit'sreallyclean.

If it's still “yes, I really do need a new car,” the shopping process begins.Researchandselectionprocesscan'tbefullyaddressedhere,butyoushouldatleastexaminealternativestobuyingabrandnewcar.AutoretailerslikeCarMaxandAmerica'sCarMartbringwell-qualifiedcarsatattractivepricesandwithouttheusualvagariesofbuyingausedcar.

Question57:Ireallydoneedanewcarnow.Leaseitorbuyit?Leasing is a means of financing a car through what amounts to an extendedrentalperiod.Withalease,yougetpossessionandallnormalvehicleoperatingcostsforaspecifiedperiod,usuallytwenty-fourtoforty-eightmonths.Paymentsappearattractive;theyarelessthanatypicalcarloanpaymentbecauseyoudon'tbuildequity.At theendof the lease,you turn in thecar,owningnothing,andideallyowingnothing.

Thereare twomajordrawbacks.First,asmentioned,youbuildnoequity inthecarandstartfromscratchatthebeginningofeachleaseperiod.Second,mostlease contracts havemodest mileage allowances, often only 10,000 to 12,000milesperyear,beyondwhichsubstantialpermilechargesapply.Damagetothecar can be assessed and billed at high prices. Initial down payments are lostcompletely,andtransactioncosts(taxes,registration)occureachtimeyouenteranewlease.

Leases can make sense in certain short-term situations: if your businessrequiresarelativelynewcareverytwotothreeyears(e.g.,arealestateagent)orifyouanticipatechanges inyourautomotiveneeds.Otherwise,mostarebetteroffwithregularpurchasefinancing.Mostimportantly,don'tchooseacarbasedon financing. Separate the purchase decision from the financing decision—otherwiseyou'relikelytoplayintothedealer'shand.

Question58:Ineedanewrefrigerator,andtheappliancestoreisoffering“sixmonthssameascash.”ShouldIbeimpressed?“Sixmonths same as cash”means you don't have tomake a payment for sixmonths.Itisessentiallyfreefinancingfortheperiod,whichcanbeattractive,butbe careful.When the free (or sometimes reduced) interest period expires, anyremaining balance will be charged full interest retroactive through the entireownership period.That is, if youbuy a $1,500 refrigerator andhave a $1,000balance in six months, you will be charged $90 back interest (if the normalannualinterestrateis18percent),andmonthlyinterestwillstartatthatrateuntilthe balance is paid. Late payments on other debt may also trigger normalinterest.Soifyoucanpayitoffinthe“free”period,goforit,butifthere'sanychanceyoucan't,lookout.

Question59:Myfamilyreallywantsanew$3,000plasmatelevision.HowshouldIevaluatewhetherIcanaffordit?The first step is to appraisewhere you arewith your other finances.Are youkeepingupwithyourplan,includingpayingroutineexpenses,coveringpossibleemergencies, andachievingother savingsgoals? If theanswer is “yes,”you'rereadytoconsiderthispurchase.

Thenextstepistoevaluatethepurchaseitself.Isitreallynecessarytospend$3,000 on this luxury item? Are there less expensive alternatives? LCD TV?More traditional large-screen technologies?Where on the “technology curve”arewe?Isthisproductlikelytobeoutdatedinafewyears?Willthepricecomedown? Research—not just one salesperson's opinion—is required. Readmagazines, look at Web sites, and talk to “smart friends” who follow thetechnology.

Finally,whenthechoiceismade,considerthefinancingalternatives.Decide

ifitmakessensetotapanalready-existingsavingspool(withoutcompromisingsome other objective). If savings aren't available, does your budget carry thecapacitytoserviceanewdebt?Canyougetadiscountbybuyingtodayinsteadof tomorrow? If the answer is “no,” the timemaynotbe right.Look intobuysomethingcheaperorlaterandprepareforit.

Question60:Whatarethealternativestobuyingexpensive,newstuff?Bigpurchases,whenhandledpoorly,canbecomethebudgetbusterwealldread,settingfinancesbackforalongtime.Beforebuyinganything—fromapressurewashertoanewcar—considerthefollowing:

Cleanit.Itisamazinghowmuchmorewelikeacaroranoldgasgrillwithalittletimeandeffortspenttoreallycleanitup.Thecleaningcanbedoneprofessionallyatacarwashorwithold-fashionedelbowgrease. Ineitherway, the amount ofmoney you'll save over a lifetimewith this approachcanbewellworthit.

Fixit.Itmaynotmakesensetofixa$25toaster,butbiggeritemslikecarsandlawnmowersmaycostyoulessinthelongruntofix.Aruleofthumb:any repair that costs less than 40 percent of replacement purchase priceshould be seriously considered. Also to consider: does replacement alsoachieveothercostsavings,likereducedenergyusage?

Rentit.Rentingdoesn'tworkforeverything,butifsomethingisusedonceinawhileandisexpensivetoacquireandmaintain,rentingcanworkwell.Thinkaboutrentinglargehomemaintenancetoolssuchaspressurewashersandrototillers.Considerrentingrecreational itemsusedonlyoccasionally,likeboatsandcampers.

Youmaystilldecide tobuy,but ifyouconsider thesealternatives,you'llatleastfeelbetteraboutyourpurchase.

Question61:Myfriendsalwaystrytoimpressmewiththeirpurchases—boats,vacationhomes,andsoforth.ShouldIbe

impressed?Thegeneralrule:so-called“luxury”orlifestyleexpansionpurchasesshouldonlybeundertakenonceotherfinancialneedsaremet.Ifmonthlyexpensesaremet,emergency reserves set aside, college and retirement plans on track, and debtlevelswithincontrol(andcouldbepaidoffimmediatelyifnecessary),youmayconsidersuchpurchases.Boats,motorhomes,vacationhomes,swimmingpools,timeshareunits,andsportscarscanbreakanybudget—especiallywhencostsofownership are included. These purchases should be avoided by most. Plancarefully.

Question62:ShouldIbuytheextendedwarranty?Extended warranties can give some peace of mind, especially when buyingcomplexproductslikeautomobiles.However,beawarethatmanyretailersandmanufacturers make more money selling the warranty than the product. Thatshouldtellyousomething.Also,manycreditcards,especiallythepremiumgoldorplatinumvarietyofferanextendedwarrantyoftheirownonitemspurchased—for free. Finally, the cost of the warranty can run 40 to 50 percent of theproduct price; you're better off to save and replace—to self-insure—theunlikelihoodoffailure.Thequalityofmostproductssoldtodayishighenoughthat failure rates are relatively low. Theremay be some products, like laptopcomputers,wherethewarrantyextendstocoveraccidentaldamage;thiscanbehelpfulifyouanticipate“rough”ownership,butbecarefulnottopaytoomuch.

PARTII

PlanningforLifetimeGoals

S

Chapter7

BUYINGAHOME

peaking of big purchases, let's address one of life's biggest financialdecisions—buying a home. The size and importance of this purchaseshouldnotbeunderestimated,andthetechnicalitiesoffinancingshouldbe

wellunderstood.Abaddecisioncanleadtothousandsofdollarsofunnecessaryexpenselateroreventhelossofyourhome.Likewise,doingitrightcanbringenormous personal and financial rewards. Few events have greater impact onfamily life or finances. More than anywhere else, you need to separate thepurchase decision from the financing decision and keep a cool, rational headthroughouttheprocess.

Question63:Everybodysaysbuyingahomebringsanumberoffinancialbenefits.Aretheyright?Why?Inmostsituations,theshortansweris“yes.”Buyingahometoliveinnotonlyprovidesneededshelterandgivesasourceofpride,butitalsohelpsfinancially.Here'show:

Forced saving. With traditional mortgage financing, a defined andsteadilygrowingportionofyourpaymentregularlygoestoequity—yourownershipinthehome.Taxbenefits.Homeownershipbringsalargeanduniquetaxbreakintheform of a $250,000 ($500,000 if married) capital gains exclusion onhomeappreciation.Formost homeowners, this is thebiggest taxbreakthey'll see in life. Additionally, mortgage interest cost is income taxdeductibleformostpeople. Safe appreciation. Real estate price appreciation has been relativelysteady over time compared tomost assets, and homes provide a hedgeagainstinflation. Reduced need for other things. Own a home, and you'll feel less

compelledtotakethat$1,000weekendtrip. Opportunity to build “sweat equity.” The possibility of homeimprovementprovidesauniqueopportunitytobuildwealththroughyourownlaborandtalents.

Itisthesynergyofthesebenefitsthatreallybringsfinancialsuccess.Stand-alone factors like themortgage interest deductionhelpbutby themselvesmaynotjustifythepurchase.Bekeenlyawarethatnotallhomepurchasesworkout,andmanycreateotherfinancialburdenslikehomemaintenance.

Question64:WhatkindofhouseshouldIbuy?Obviously location and personal taste play a big role in selecting a home.Financially,ithelpstobuyahomethatyouwillbehappywithforalongtime,asmovingcostsandthebuy/selltransactionsinvolvedareexpensive.Youwantaplacethat,careertransfersaside,youwanttoliveinforfiveyearsormore.Soithelpstostretchalittletobuysomethingbetter,somethingyouandyourfamilywillconsidera“home,”notjusta“house.”Adding“sweatequity”throughyourown improvements also helps in the long term, so look for a home that isn'tperfectandthatwillbenefitfromimprovement.

Question65:HowdoItellifahomeisoverpriced?Rapidhomepriceappreciationduring2001–2005hasbroughtthisquestionintothespotlight.There isnoperfectguide,butyoushouldbewaryofbuyinganyasset experiencing rapid recent appreciation.Anything appreciatingmore than10percentperyearisobviouslygrowingfasterthantheeconomyandinflationasawhole,andsuchgrowthisunsustainableinthelongterm.

Certainlyyou'llwanttoreviewcomparablesalesinyourarea,whichcanbedone by your realtor or through various real estate portals, like Yahoo!RealEstateortheNationalAssociationofRealtors(www.realtor.com).Buttherentalreturn-on-investment model is another rational approach. If rented, would therentonthepropertyprovideareasonablereturntotheowner?Ifyou'relookingata$400,000homethatwouldrent,bycomparativeanalysis,for$1,200/month,thatwould provide an investor $14,400/year on $400,000, amere 3.6 percentreturn before expenses. Is that a good return? No—either the rent is too low

(unlikely)orthepriceistoohigh.

Question66:HowmuchhousecanIafford?Youranswerdependsonbothincomeandassets.Thegeneralruleholds thatamortgage payment should be nomore than 28 percent of your gross income,although this rule has flexed a bit in recent years. If your earnings (combinedearnings, ifappropriate)are$75,000/year, then28percentof thatfigurewouldbe $21,000/ year, or $l,750/month. At a 6 percent mortgage interest rate forthirtyyears,thatpaymentworksbackwardintoaloanamountof$291,885.Withatraditional20percentdownpayment, thatgivesamaximumaffordablevalueof$364,856.Adjustablemortgages (ARMs)canaffordmore,butkeepinmindthatpaymentswillincrease,demandingincreasedincometostayoutoftrouble.Thisscenariorequiresafairlycleandebtslate(withamonthlyservicingcostforall other debts of less than 10 percent of gross income) and does not includeothercostsofhomeownership,suchasproperlytaxes,homeowner'sinsurance,andmaintenance.

Question67:CanIbuyorsellahomewithoutarealtor?Theshortanswer:yes.Whileconvenient, realtorsarenot requiredby law,andtheycanaddasubstantialtransactioncost(usually6percentofpurchaseprice)tothetransaction.Tobesure,asabuyeryoudon'tavoidthisfeebyhavingtheseller pay—it is ultimately built into the sale price of the home. Thetechnicalitiesofa realestatecontractaren'tmuchmorecomplex thanstandardincome tax forms and vary by state. Get a copy of the standard real estatepurchasecontractused inyourstate(afilled-outexamplewouldbebest).Thisisn't tosayyoudon'tneedprofessionalhelp;youshoulddeveloparelationshipwithanattorneyand/oranescrowofficer.Thesefolkscangiveadvice,helpwithtechnicalities,andshouldbeabletohelpwithforms.Sellersmayoffertopayanescrowofficerasmallfeeorgratuityforhelp,astheyaretypicallypaidonlytofinalize and record transactions. Marketing—finding buyers—is the biggesthurdle for do-it-yourself sellers. A professional approach with well-craftednewspaperads,openhouses,etc.,usuallyworksifyourhouseispricedproperly.Discountrealtorscanalsobeattractive,butbeclearonwhatyou'regettingforthereducedfeesof2to3percent.

Realtorshelpbuyers findhouses,but Internet resourcesare improving.Theonceexclusive“MultipleListingService”isgenerallyavailableonline.Youcanenteryoursearchcriteriaandselecthomes—eventhoseforsalebyowner—withaclickofamouse.

Question68:Obviouslythemortgageisabigfactor.WhatkindshouldIgetandwhy?Choosing a mortgage is more complex than can be fully explained here, butchoices exist among the term and type ofmortgage.Most terms are fifteen orthirty years, with a few at ten and twenty years. The difference in paymentbetweentheshortertermandlongertermmortgageisnotasgreatasyouwouldthink,andtheinterestcostavoidedandfasterequitybuildupareveryattractiveforlong-termwealthbuilding(asdemonstratedinQuestion70).Fixed and adjustable are the two primary mortgage types. With a fixed

mortgage, interest rates and payments remain unchanged for the life of themortgage. Adjustable mortgages have different interest rates and differentpaymentsdependingontheprevailinginterestrates.Whiletheinterestratehasanupperlimit,or“cap,”anunfavorableclimatecandriveyourpaymentsmuchhigher. For a 30-year, $300,000 mortgage, a 1 percent increase in rates addsnearly$200tothepayment.Manyadjustablemortgagesofferlow“teaser”ratesthatmayappearattractivetoday.ARMscanworkbutaremoredangerousinalowinterestrateenvironmentbecausethemorelikelyupwardratetrajectorycanbehazardoustoyourfinancesunlessyouexpectyourincometogrow—amoredubious proposition in an environment of increasing rates. Opt for the fixedmortgageifyoucan,unlesscurrentinterestratesarehigherthanhistoricnorms.

Question69:Howbigshouldmymortgagebe?Ifpossible,youshouldborrownomorethan80percentofthevalueofthehome.Why? Because most lenders require PMI—private mortgage insurance—tocovertheloanshouldyoudieorbecomedisabled.PMIaddstothecostofyourhomeandbringslittlepeaceofmindotherthanforthelender.

Somelenderswillloan90percent,95percent,andevenhigherpercentagesofLTV,orLoantoValue,butthisusuallybringshigherinterestratesinadditiontoPMI.Mostpeoplefinditmorecomfortabletoputmoredownandgetasmaller

mortgage if they can.With today's homeequity lines, that additional equity isnotastiedupasitoncewas.

Question70:ShouldIgetathirty-yearmortgageorsomethingshorter?For a $300,000 mortgage, a thirty-year loan at 6 percent requires a monthlypaymentof$l,798/month,whilethefifteen-yearequivalentis$2,531/month.Soforanextra$700/month,youcanbemortgage-freeinfifteenyears.Putanotherway, in fifteen years you will accumulate $300,000 in equity—savings—comparedtoabout$87,000withthethirty-yearmortgage.

The following table, based on the same $300,000 mortgage at 6 percent,showsthedifferenceinpayments,totalinterestpaidoverthelifeoftheloan,andequityaccumulationafter tenyears.Theadvantagesofshorterloanperiodsareobviousandshouldbepursuedifincomepermits.Mostmortgagelendersofferslightlypreferredrates,¼to½percentless,forshorterterms.

Withmostmortgages,youcanmakeextrapaymentstoshortenthemortgage,save interest, and increase equity buildup. While pursuing this option canpreserve flexibility to handle income shortfalls, many people don't have thedisciplinetosustaintheextrapayments.

Question71:Whyareinterestratessoimportant?Dotheyreallymakeadifference?WesawinQuestion68howa1percentinterestrateincreaseona$300,000loanincreases themonthlypaymentby$200.Youcan interpret this figure foryourownsituation:ifyouhavea$200,000loan,theincreasewillbeabouttwo-thirdsasmuch,orabout$130.Notethatshortertermloansaresomewhatlessinterest-

sensitive;thesame$300,000loanpaymentoverfifteenyearsonlyincreasesby$165/month,orabout6.5percent,foreach1percentchangeintheinterestrate.

Question72:Whatmakesmortgagerateschange,andwhatshouldIkeeptrackofandwhy?Mortgagesareessentiallybondsthatyousell.Aninvestorbuysthe“bond”fromyou, loaning you money today with your promise to pay in the future withinterest.Therefore,mortgageratesarelargelydictatedbythebondmarket—themarket for loaned funds.Sincemortgagesare long-term instruments, the long-termmarketforloanedfundsismostimportant.Prospectivemortgageesshouldmonitor changes in long-term bond rates, particularly ten-year U.S. Treasurybondsandsimilarinstruments.

It is also important tomonitor factors thatdrive these rates. Inflation is themost importantdriversince itaffects the realvalueofdollarspaidback to thelender.High inflation leads tohigh interest rates, asgovernmentpolicymakerstypicallyuseinterestratestocontrolinflation.Sofactorssignaling—orcausing—inflationareimportant,suchasrawmaterialprices,strongeconomicgrowth,and rising labor costs. In thinking through this, you'll realize that the lowestinterestratesareavailableduringweakeconomictimes—whichmayormaynotbewhenyou'rereadytobuy.

Question73:Whataretherealcostsofowningahome?Likeanyasset,onemustbeawareofthetotalcostofownershipofahome.Thefirstandmostobviouscostisthecosttopurchase.Fortunately,thevastmajorityof homeowners have experienced no decline in valuewith time or use of thehome; in fact, it isquite theopposite.Sopurchasepriceusuallydoesn't figureintothecostofownership.

However,mostpeoplemustobtainfinancingtoaffordthepurchaseprice,andthecostofthisfinancingissubstantial,evenwithtaxbenefits.Fora$300,000,6-percentmortgage,youwillpay$347,000ininterestovertheloanlife.Evenifyouareabletodeductthisamountonyourtaxes—savingpossibly35percent,itstill costs $225,000 of real, earnedmoney, or $7,500/year over the thirty-yearperiod.

Thecostsdon'tstopthere.Propertytaxes,onaverage,runabout1.5percent

ofthehome'svaluebutcanvaryalotdependingonlocation—upto$6,000/yearon a $400,000 home on average and to $15,000 or higher in some high-taxlocales.Homeowner'sinsurancemayrunanother$1,000moreinareaspronetocrimeornaturaldisasters.Afterthat,themaintenancecostsvaryaccordingtothehomeandhowyoudecidetokeepit,butyoushouldfigureatleast1percentofthevalueof thehomeeachyear andmore if thehome isolder. In total, thesecostsusuallyadduptobetween3and10percentofthehome'svalue.Thisisn'ttosayyoushouldn'townahome,butyoushouldbeawareofthecosts.

Question74:Whatareclosingcosts,andhowshouldtheybepaid?Closing costs are normal transaction costs for transferring real estate from theseller to thebuyer.Theyvaryby state to a degreebut usually include interestadjustments,properly taxadjustments, title insurance,escrowfees,andvariouspublicandprivatefeesfortransactionrecording,inspections,andappraisals.

Interestadjustmentssimplybringinterestpaymentscurrenttothefirstofthenext month, the beginning of the normal monthly mortgage payment cycle.Propertytaxadjustmentsaresimilarexcepttheyareadjusted,orprorated,tothefirst of the next tax period.Title insurance protects you (and the lender) frompotentialtitleconflicts.(Didthepreviousownerindeedowntheproperly?Werethere some “liens,” claims as loans or otherwise, against it?) Escrow fees arepaid tomanage the transaction details, exchangeof funds, paperwork, and theofficial closing and recording at the local public agency. Then other fees areadded for inspections as requiredby local lawor asnegotiatedbetweenbuyerandseller,andtherewillbeminorrecordingfeesassessedbythecounty.Somejurisdictions also charge transfer taxes, akin to sales taxes, and many escrowofficeswillchargefees fordocumentcreationandexpressdelivery.The list islong,andyouhaveeveryrighttounderstandeachitem.

Typicallyclosingcostsarenegotiatedbetweenthebuyerandseller.Thesellermight pay for escrow, title insurance, and all required inspections while thebuyer picks up discretionary inspections and the appraisal. The buyer paysinterest and tax adjustments since they will own the properly during theadjustmentperiod.

Question75:WhenshouldIconsiderrefinancing?

Typicallyrefinancingisconsideredif(1)youplantostayinthehomeforatleastfivemoreyearsand (2) if the interest ratewoulddeclineabout2percent.Thedecisiondriversareclosingcostsandthesizeofthemortgage.Dothepotentialpayment savings during the next few years of ownership pay the costs? Thedecisionrequirescarefulcalculationofclosingcosts.Manyrefinancelendersarepicking up someof these costs,making the propositionmore attractive. Somehomeowners, especially with large mortgages, are finding it attractive torefinancewith as little as a1/2percentdrop in the interest rate. It alsomakessense to refinance to move from an ARM to the stability of a fixed ratemortgage.

Question76:ShouldIconsiderpayingoffmymortgageearly?Whyorwhynot?Asidefromrefinancing,thisisoneofthemostcommonquestionsduringhomeownership,andfinancialadvisorsbringwide-rangingopinionstothetopic.

The answer, for most, is probably “yes.” First among the many principlesinvolved:youshouldifatallpossiblepayoffyourmortgagebeforeretirement,greatlyreducingrequiredcashflow.

Payingamortgageearlysavesinterestcostandputsyouinafarmoresecureand flexible financial position. It's equivalent to buying a bond at the samecoupon,orinterestrate,asthemortgageratesinceyouaresavingthatamountofinterest.Asaninvestment,thisworksunlessyouspendthesavedproceeds.

The counterpoint: paying off the house ties up funds in the real estate,denyingpotentiallyhigherreturnsavailablefromotherinvestments(likestocks).However,consideringrisk,thetradeoffmaybefavorableespeciallyifyouhaveother funds to invest. Others argue that capital tied up in home equity isinaccessible,evenforemergencies.Thewideavailabilityofhomeequitycreditlinesmakesthislesstrue.

Todayyoumaystillencounterfinancialadvisorsrecommendingagainstearlypayoff,butonemustsuspectmotives,asitremovesmoneyfromtheiroversight.If other financial needs aremet and income is reasonably stable, early payoffmakessense.

Question77:MyfriendstellmeIshouldbuyrentalproperty.Is

thisgoodadvice?WhatdoIneedtoconsider?Rentalpropertyhashistoricallybeenagood investment formost, as rents andpropertyvalueshaveboth risen steadily.While itmay takeawhile to recoverinsurance, tax, andmaintenancecosts through increased rents, eventually it allseemstoworkout.

However,manypeople fail toconsiderallof thecosts—including timeandeffort—of maintaining a rental property. For many, taking care of their ownhome isenough.Nowtheyare in thepositionof landlord,having todealwithtenantsinwhatisoftenastressfulsituation.Finally,landlordsmustdealwithatleastsomevacancy.Thepropertywillnotberented100percentofthetime,andsomeeffortandcostwillhavetogotowardreplacingtenantsfromtimetotime.

Buying a rental property shouldbe lookedat like starting abusiness.Whatarethepotentialrevenues,costs,anduncertainties?Doesitpencilout?Doyouhave the skills, time, patience, and risk tolerance to run the business? If so, itmaybeforyou.

F

Chapter8

PLANNINGFORCOLLEGE

orfamilieswithchildren,thecostofcollegeisoneofthebiggestfinancialhurdlesencounteredduringa lifetime.Today's jobmarket requires someformofformaleducationasalmostagiven.Collegeisexpensivetobegin

with,butcostshaveescalatedrelentlesslyandareprojectedtoescalateabout6percentperyear.This isdouble the rateof inflation,but the trulybadnews isthat state budget problems are driving a projected 10 percent rise in publicuniversitytuitions.Planningforcollegemustbedonecarefully,but,asshowninwhatfollows,therearemanywaystodoit.

Question78:Howmuchdoweneedtosaveforcollege?The amount needed to fund a college education depends on the number ofchildren you have, kind of college they might attend, and projected costincreasesfor thatcollege.There isabigdifferencebetweencostsofpublic in-state, public out-of-state, and private colleges. The location also affects livingcosts; colleges in urban areas costmore. The financial habits and standard ofliving of your offspring are also important, and don't forget to includetransportationcostifsomethingotherthanon-campuslifeisintended.

TherearegoodInternetresourcesavailabletotrackcurrentcollegecosts.TheCollegeBoardWebsite(www.collegeboard.com)givescurrentcollegecostsforindividualpublicandprivateschools.Toproject thesecosts forward,enter theappropriatecostgrowth rateand thenumberofyearsbeforecollegestarts intothecompoundingformula:

Futurecost=Currentcost×(1+growthrate)numberofyears

Soacurrentcostof$7,000/yearwouldgrowto$12,535ata6percentgrowthratein10years($7000×[1.06]10).Tobereallyprecise,youshouldrepeatthecalculation foreachof the fouryears tobesupportedandadd the results fora

totalfigure.

Question79:Whatarethemainwaystofinancecollegecosts?Themanytraditionalandcreativeways tofinanceacollegeeducationfall intooneofthreecategories:

Savings plans accumulate funds or prepay tuition (a form of savings)usuallywithfavorabletaxconsequences.Normalhouseholdsavingsandrealestateequityfigurein,too.Taxreliefgoesbeyond tax-preferredsavingsplanswith specificcreditsandtaxdeductionsforcollegeandcollege-relatedcosts.Financialaid supplementsyoursavings throughasystemofgrantsandloans.Some,butnotall,aidisbasedonneed.

Thebeststrategyis tobuildsavingsfirst, thenuseaidandtaxbreakstofillthe gaps. People tend to depend toomuch on financial aid. Instead of saving,they support an excessive standard of living and rely on aid—with lastingnegativeeffects.

Question80:Whatarethebestsavingsalternatives,andhowdotheywork?Specialized college savings plans give a tax break on earnings (not originalprincipal)addedtoanaccount.Inthecaseof529plans,investmentsaregearedtowardcollegesavings.Thethreemaintypesare:

Coverdell IRAs (onceknownasEducational IRAs)allowa$2,000annualcontributionperchild fromanyone (itdoesn'thave tobeaparent).Thesefunds can be invested as you wish, and investment gains are tax-free.Householdincomemustbelessthan$190,000tomakeafullcontribution.Advantages include investment flexibility; disadvantages include thelimited contribution. It's hard to accumulate all college needs at$2,000/year,andyoumayhavetopaysomeonetomanagetheinvestments.

QualifiedStateTuitionPlans,orQSTPs,come in twoforms:Section529

tuition prepayment plans and college savings trusts. Prepaid tuition planshave been around for some time, while 529 savings plans are relativelynew.Botharediscussedinmoredetaillaterinthischapter.

Educational SavingsBonds are Series I or EE bonds offered by theU.S.Treasury.Thesebondsaresafe.I-bondshaveaninflation-indexingfeature,butratesarelow(3.39percentforfall2004).Theyarestateandlocaltax-exempt and can be federal tax-exempt if used for qualified educationalexpenses if you are in qualifying tax brackets. For details, see the U.S.Treasurysavingsbondsite(www.pblicdebt.treas.gov).SeriesEEbondsareissuedatadiscountanddon'thavetheinflationprotectionfactor.

Question81:I'veheardalotabout529plans.Whatarethekeyfeaturesandprosandcons?529 savings plans are college savings trusts set up under Section 529 of theInternalRevenueServicecode.Withincertainguidelines,eachstatecansetupatrustmanagedbyaninvestmentcompany.(TIAA-CREFisthelargest,butthereareothers.) Investorsget somebutnota lotofchoiceof investments—usuallyconservative equity funds, bond funds, or a self-directed or automaticallyreallocatedmixofthetwoinvestments.Earnings(notoriginalcontributions)aretax-free. The biggest advantages are the large maximum contribution limit(usually greater than $200,000 per child), automatic payment programs, andspecial estate planning consideration.There are no income limits, and eligibleexpensesarebroadlydefined to includecollege livingexpenses.Special estateplanning considerations include acceleratedgifting,whereup to five times thenormal$11,000exclusioncanbegiftedtax-freepergiverperrecipient.Retainedownership allows a grandparent donor to set the trust in their name with agrandchild as beneficiary, effectively transferring the assets but retainingcontrol. (If the assets must be retained for use by the elder and not foreducationalpurposes,a10percentpenaltyapplies,butthisisfarlessexpensivethan paying estate or gift taxes.) 529 planswork for all savers and especiallywealthyfamilies.Disadvantagesincluderelativelypoorinvestmentreturns,highfees in some plans, and inflexible investments. The College Savings PlanNetwork portal (www.collegesavings.org) gives a good summary of each stateplan.

Question82:HowdoIchooseastateforour529savingsplan?Every state has a slightly different plan—different investment advisors,investments,fees,andpastperformance.Youcaninvestinanystate.Choiceofstate is really a matter of personal preference for investment choices, trackrecord, and fees. Some states offer a state income tax preference for fundsinvestedintheirownstate.

Question83:Whataretheadvantagesanddisadvantagesofprepaidtuitionplans?Prepaidtuitionplansarethepredecessorsoftheevermorepopular529plans.Aprepaidplanallowspaymentof in-statestatecollege tuitionatadeepdiscountwell in advance of enrollment, either as a lump sum or a series of regularpayments.Butnotallstatesofferthem,andwhilegenerallytheycanbeusedforprivate schools or state schools in other states, theremay be strings attached,suchaswithdrawal feesand forfeited returns.Theydon'tguaranteeadmission,and they only pay for tuition and fees, not books, living, and transportationexpenses. Most prefer the more flexible and expense-inclusive 529 savingsplans.

Question84:Whatarethemajorformsoftaxreliefforcollegecosts,andhowcantheyhelp?The IRS offers a complex and frequently changing set of tax credits anddeductions to help offset some, but not all, college costs. These tools aretypicallyonlyavailableforfamilieswithadjustedgrossincomeunder$130,000($65,000forsingleparents).

The Hope Scholarship Credit is a tax credit (which is better than adeduction) of up to $l,500/year per student for qualified educationalexpenses during the first two years of school. Qualified educationalexpensesonlyincludetuitionandfees,notlivingexpenses. The Lifetime Learning Credit picks up where the Hope ScholarshipCredit leaves off, giving a credit of 20 percent of the first $10,000 ofqualified expenses for amaximum annual credit of $2,000 per family.

Onlytuitionandfeesarecovered,buteducationisdefinedmorebroadlytoincludeprofessionaltrainingandseminars. Up to $2,500 of student loan interest is deductible against income, ifincomequalificationsaremet.

FortheHopeScholarshipandLifetimeLearningcredits,thereisa$4,000capperyearperfamily.

Question85:Whatarethedifferentkindsoffinancialaid,andwhichisbest?Beyond savings and tax incentives, there are a variety of aid plans.Most areofferedorsupportedby thefederalgovernment;somearefromstates,schools,or private foundations. The twomain categories are grants and loans. Grantsaren'tpaidbackandareusuallybasedonneed.Loansmayormaynotbebasedonneedorhavedifferenttermsdependingonneed.

Major federal grant programs include Pell and Supplemental EducationalOpportunityGrants,whichrangefromafewhundreddollarsto$3,000(Pell)or$4,000(SEOG)peryear.Bothconsiderfamilyneed.

Loanprogramsareextensiveandhavevariedfeatures.Somehavepreferencefor studentswith need. Some loans aremade to students, and some loans aremade to parents. Some loans are for undergraduates, while other loans covergraduatestudentsorboth.Mosthavefavorableinterestratesandpaymentterms.

Perkins loans are targeted toward families with high need and canfinanceupto$20,000(undergraduate)or$40,000(graduate)inexpensesat a maximum interest rate of 5 percent with payments deferred untilaftergraduation. Stafford loans aremade to students and provide increasing amounts asthe student progresses through college.Theymaybe subsidized (lowerinterestratesqualifiedbyneed)orunsubsidized.Loanlimitsarehigh,upto$10,500/yearforundergraduatestudentsand$18,500/yearforgraduatestudents.Interestratescannotexceed8.5percent.Adisadvantage:theseloans aremade through private institutions (banks),whichmay chargeheftyoriginationfees.

Parent Loans to Undergraduate Students (PLUS) loans are made toparents andhavevariable interest rates, not to exceed9percent.Theseloans can originate at private institutions or directly through the U.S.Department of Education. Balances are limited only by education costandmaybepaidoffinpartthroughpublicservice.

Question86:How“poor”dowehavetobetoqualifyforfinancialaid?The financial aid process is complex, but it usually starts with submitting astandardformknownastheFreeApplicationforFederalStudentAid(FAFSA).Theformdetailsfamilyassetsandincome,andfinancialaidofficersdetermineanEFC,orExpectedFamilyContribution,fromthedatasupplied.Theformulais complex, but it considers a combination of assets, income, age, number ofchildren, and special financial circumstances. Primary residences, farms, andretirement plans are generally excluded. A rule of thumb: a parent might beexpected to supply on average, depending on income, 10 to 12 percent of netassets,whileastudentmightbeexpectedtosupply35percentofnetassets.(Sodon't give toomuch to the student in advance.)The percentage climbs fast asfamily incomeincreases.Furtherdetailsareavailable in theCollegeCostsandFinancialAidHandbookpublishedbytheCollegeEntranceExaminationBoard.

Question87:What'sthedownsideofstudentloans?Many families depend on student loans as the solution to get them throughcollege costs requirements.Butbeware:debt is debt.Whetherobtainedby thestudent or parent, these loans need to be paid off. Five or ten years of debtpaymentsbynewlyemployed students can setback their financesand savingsplans.Wouldn'titbebettertostarttheirretirementsavingsearlywithfortyyearsof compounding? As for the parent, payments could instead go to retirementpreparation—paying off the mortgage, for instance. While interest rates arecapped, they are still high by 2004–2005 standards. Loan fees, especially forStaffordloans,canbeexpensive.

Question88:ShouldIborrowagainstmyhomeequitytofinance

college?When college requirements arrive, many families find their biggest asset andsource of cash is the equity in their homes. Should they borrow against it forcollege?Homeequity loan interest ratesandprobable interest taxdeductibilityareattractive.Obtainingtheloaniseasyandisdevoidofcostifthecreditlineisalreadysetup.While theseprosareattractive, it reallydependsonthestateofother retirement assets. If retirement is sufficiently funded elsewhere, tappinghomeequitymightbesound.However, if retirement isaquestionmark,homeequity(andotherassets,totheextentpossible)shouldbepreserved.Why?Anyadvisorwill tell you that you can borrow elsewhere for college, but you can'tborrowforretirement.

Question89:Givenallthetools,whatisthebeststrategyformeetingcollegeneeds?Whether you are of high, low, or average means, planning for college takescommitmentandcreativity toeffectivelyuse the strategiesand toolsavailable.People ofmodestmeans are advised tomake full use of available tax breaks,loans,andgrants.Thismeanskeepingupwiththerulesandwatchingthecostsand aid policies of chosen colleges.Even a trickle going into savings plans—Coverdell or 529—makes sense and is easy, particularly with 529 monthlypayment plans. These plans effectively employ a “dollar cost averaging”approachandhavethepotentialtomakeabigdentoverthelongrun.Amonthlydepositof$50madeoverfifteenyears,assuminga6percentinvestmentreturn,provides$14,540,enough topayayearor twoofcollegecosts (dependingontuitioninflation).

Wealthier familiesmight lose some of the tax breaks and preferential loantreatment,buttheycanmakefulluseofthe529savingsplans,especiallyintheestate plans of elder family members. The gifting rules for 529s make itextraordinarily easy to transfer assets to other family members—for a goodcause—while still preserving ownership and control and enjoying tax-freegrowthandcompounding.

R

Chapter9

PLANNINGFORRETIREMENT

etirementplanning is thedevelopmentofa financialplan tocoveryour“golden years,” where your ability—and willingness—to work forincomedeclines.Retirementplanningusedtobesimple—turnsixty-five,

collectSocialSecurityandanemployerpension,movetoFloridaorCalifornia,and live happily ever after. Just like about everything else, that's all changed.The age sixty-five cutoff is no longer a given.Many peoplewant to retire orsemi-retire early, and many people intend to stay active and work longer.“Automatic” pensions are disappearing in favor of self-built and self-directedretirementassets.Earnedincomeisreplacedwithincomefromyourassets,andhow that happens is your responsibility. The bottom line: retirement planninghasbecomebothmorecomplexandmoreimportant.

Question90:EverydayIreadabouttheimportanceofretirementplanning.Whyhasitbecomesuchabigissue?Putsimply,youneedmoreatatimewhenyou'reguaranteedless.You'relikelytolive longer,retireearlier(orat leastwant to),andwantahigherstandardoflivingduringretirement.Youwanttotakevacations,visitdistantgrandchildren,and live comfortably. At the same time, employers are dropping guaranteedpensions,SocialSecurityisgraduallyreducingbenefits,andfinancialassetsaremorevolatile.Thereplacementofdefinedretirementbenefitswithself-directedretirementplansisonebigmanifestationofthistrend.

Question91:Whatarethemajorelementsofaretirementplan?

Retirementplanshavethreemainparts:

Total needs analysis addresses how much will be needed over whatperiodoftime.Thefirststepisdecidinghowlongyouarelikelytolive,andthesecondstepisprojectingthestandardoflivingyouaspireto.6/28/2011Determiningentitlementsisthesecondpartofplanning.What“guaranteed” benefits are you entitled to? Social Security is mostcommon,butpensionsandotherannuitiesarealsoconsidered.Net needs analysis subtracts entitlements from total needs; this iswhatyouneedtoprovideintheformofsavings.Theamountdependsontimeuntilretirementandinvestmentreturnassumptions.

Question92:HowdoIdeterminemytotalneedsforretirement?ArethereanyfactorsIcancontrol?Totalneedsisbasedonlengthoflifeafterretirementandthestandardoflivingdesired.Lengthof life isaneducatedguessatbest(anddon't forget to includeyourspouse).Today'slifeexpectancyrequiresplanningforatleasttwentyyears;many lookout to twenty-five to thirtyyearsandnaturallymore if theyplan toretireearly.

The next step is estimating income required to support your standard ofliving.Mostneed70to80percentoftheirgrossincomewhenworking.Thiscanvarydependingonhealth,whetheryourhomeispaidfor,andmoregenerallytheretirementlifestyleyouwanttolive.Ifyouwanttotraveloverseaseachyearandmake three cross-country trips per year to visit grandkids, plan for more. Ifretirement includesamotorhome,boat,ornewcarevery threeyears,plan formore.Make a list of what will be cheaper andwhat will bemore expensive.Conservative planners use 100 percent of income as an assumption, giving acushionifnothingelse.

Question93:SupposeIdecide,aftertotalneedsandentitlementanalysis,thatIneed$3,000/monthforthirtyyearsofretirementtoachievemydesiredstandardofliving.HowdoIconvertthatintoanamounttosave?

Onceyoudeterminemonthlyretirementincomeneedandtimeduration,simpledistributionannuitymathgivestheamountyouwillneedtosave.(YoucanfindafurtherexplanationofthisconceptofTheEverything®PersonalFinanceBook[AdamsMedia,2003],bythisauthor.)Adistributionannuityisasumofmoneycapable of paying a fixed amount per month while keeping retained fundsinvestedatagivenrateofreturn.Itisnotaproductyoubuy(althoughitcanbe)butratheramathematicalcalculation.

Thefollowingtable(presentedpreviouslyintheanswertoQuestion21)givesthemathematicalfactorsyouneedtomakeacalculationofhowmuchyouwillhavetosave.Atanassumed7percentreturnonretainedinvestments,theannualmathematical factor for thirty years is 12.4. So take your monthly stipend,annualizeit($36,000),andmultiplyby12.4.Theresultis$446,400tobesaved.However,thisassumeszeroinflation.Ifyouassume3percentinflationovertheperiod,“real”investmentreturnisreducedto4percent.Thefactorfor4percentis17.3, increasing thesavingsneeded to$622,800.Yes, inflationdoesmakeadifference.

DistributionAnnuityTable

Question94:WithregardtoSocialSecurity,howmuchincomecanyoucounton?Social Security is set up to provide about 24 percent of your preretirementincome,moreforlowerearners,lessforhigherearners.Todetermineyourexactpayment, Social Security uses a complex formula to calculate your Average

IndexedMonthlyEarnings(AIME)atretirement.Basedonthelatestfiguresfor2005,yourpaymentis thenbasedon90percentofthefirst$592ofAIME,32percentofthenext$2,975,andthen15percentoftheamountover$3,567,uptoa maximum monthly benefit of $1,874 for age sixty-five retirees. So if yoursalaryatretirementis$60,000andyourAIMEworksoutto$5,000/month,youwillreceive$l,699.75/month,orabout34percentofpreretirementincome.YourexactpaymentwillvaryaccordingtoyourAIME,whichinturnvariesaccordingtoyour incomehistory, so it isdifficult tocalculateyourexactpaymentusingyour current annual income.Note thatSocialSecurity, through changes in theformula and retirement ages, intends to lower the average preretirementpercentage to about 20 percent. Regardless of change, the need for incomebeyondSocialSecurityisobvious.

Question95:Iworkedallmylife,andmyspousestayedathomeandonlyworkedsporadically.HowmuchSocialSecuritywillweget?WhatifIpassaway?The general rule is that spouses get the larger of their own entitled SocialSecurity payment or one-half of your payment when they reach eligibleretirementage.So ifyou'reentitled to$1,540/monthbasedonyourAIMEandretirementageandyour spouse is entitled to$950,youwouldget acombinedtotalof$2,490/month.Ifthespousewasonlyeligiblefor$650basedonhisorherearnings,youwouldreceive$2,260/month($1540×1.5).

Ifyoudieoryourspouseisdisabledortherearedependentchildreninvolved,the scenario changes considerably. In the case of death of the primary earner,payments are available for dependent children ($1,037/month in the previousexample),andthespousalpaymentwouldincreaseto$1,380/month.

Question96:Iwasbornin1956.Whataremyretirementoptions,andhowdotheyaffectmySocialSecuritypayout?Your choices boil down to early, full, and deferred retirement. Recent SocialSecurity changes increased the full retirement age for those born after 1937,scalinggraduallyupwardfromsixty-fivetosixty-sevenyearsifbornin1960orlater.Earlyretirementcanstartatagesixty-two.Ifyouwerebornin1956,fullretirementcanstartatagesixty-sixyears,fourmonths,anddeferredretirement

startsbeyondsixty-sixyears,fourmonths.Asidefromtheeffectsofaprematuredeath,whenyouretirehasnothingto

dowithhowmuchtotalSocialSecurityyouget.Itonlyaffectswhenyougetit.Earlyretireessimplyspreadtheirpaymentsoutoveralongerperiodsothatthepayment is reduced. Deferred retirees forgo payment in years sixty-two toseventy so that there ismore available once they start to draw.The followingtableillustratesthis(basedon2004figures).

Prematuredeathistheproblemwithwaitinglonger.Ifyoudieatageseventy-two,you'llonlyreceivetwoyearsof thehigherpayment;paymentsyouwouldhavereceivedforyearssixty-twotoseventyarelostforever.TheSocialSecurityAdministration Web site has a basic benefits calculator (www.ssa.gov) toestimateyouroptions.

Question97:Idivorcedmyhusbandtwentyyearsago.Towhat,ifany,SocialSecurityamIentitled?Generally,ifyouweremarriedtenyearsormoreandhavenotremarried,you'reeligible for benefits using the standard spousal formula, that is, the greater ofyour eligible benefits or one-half of your spouse's benefit. It gets morecomplicated ifyouaredisabledorhaveadependentchildundersixteen livingwithyou;generallyyougetmoreandareeligible sooner, at age sixty inmostcases. The formulas are complex; you're best advised to contact the nearestSocial SecurityAdministration office directly. They are typically helpful. TheSocialSecurityAdministrationpublishes an excellent summary entitled “WhatEvery Woman Should Know” covering this and other issues, atwww.ssa.gov/pubs/10127.html.

Question98:Myincomeisn'tveryhighnow,notenoughtocoverbothcollegeandretirementneeds.WhatshouldIfocuson?

Withthetrendtowardgettingmarriedandhavingchildrenlaterandlaterinlife,thisisthecommonconundrumfacedbymorepeopleinmiddleage.Manyjustsavedmoneywithoutconsidering thedualneedsofcollegeandretirementandfind themselves facing college expenses—then retirement expenses just a fewyearslater.

When facedwith this dilemma, retirement should get primary focus.Why?Simply because nobody will lend you money for retirement. It is possible toborrowmoneyforacollegeeducation(seeChapter8),andit isevenplausibleforourchildrentopayforsomeorallofcollege,eithernoworeventually.Butonce precious retirement resources are committed to college, they are hard toreplace,especiallyinashorttimeframe.Sothebestadviceistosaveforbothifpossible,buttoprioritizeretirement.

Question99:Scenario:Iwasbornin1956andplantoretireatagesixty-sixyears,fourmonths,earningabout$50,000/year.Myspousewillretiretwoyearslaterwithearningsofabout$25,000.CanwerunaroughcalculationofwhatIneedtosave?First, let's simplify the calculation by assuming your spouse will retire at thesametime.Putanotherway,we'llcalculatewhatyouneedgoingforwardafterheorsheretires.BasedontheQuestions95and96(using2004figures)wecanestimate your Social Security receipts at $1,545/month. Your spouse will beeligible for$1,008/month (90percentof$531+32percentof$1,552).Sincethatisgreaterthanone-halfofyouramount,yourtotalmonthlySocialSecuritypaymentwillbe$2,553.

Nowyourstandardoflivingtodayisbasedon$75,000annualincome.Makethe assumption youwant, but let's suppose you can live on 80 percent of thatamount,or$60,000/year.That's$5,000/month.

SoSocialSecurityprovidesabouthalf;youmustcomeupwith$2,447/monthafter any applicable taxes to meet your desired standard of living, or$29,364/year. What amount of money, if deposited today, would provide$29,364/year? Let's make it an even $35,000/year to give room to pay taxes,handleemergencies,etc.

Usingdistributionannuitymath,assumingtwentyyearsof life inretirementand a 4 percent net return after inflation, the factor is 13.6.Multiply 13.6 by$35,000, and you get $476,900 in savings at retirement day one required to

sustainyourlifestyleafterSocialSecurity.

Question100:Whatarethedifferentemployerretirementplansavailable?Canyousummarize?Retirement plans and the pension and tax law that sits behind them are verycomplex and beyond the scope ofmost workers.Many specialized retirementplanformsweresetupforsmallbusiness,professionalcorporationslikedoctorsand lawyers,and theself-employed.Formostnormalwageearners, retirementplansfallintooneoftwocamps:definedbenefitand.definedcontributionplans.In defined benefit plans, the employer commits to the benefit and takesresponsibility to make it happen. Defined contribution plans define thecontribution, not the benefit. The benefit is based on what's in the plan atretirement.ThepopularIRAsareindividualplans,notemployerplans.

Traditional pensions are defined benefit plans. Pensions give what waspromised,andthecompanyislegallyobligatedtodepositenoughfundsintotheplan tomake it happen. The risks of investment performance and earning thefundstodepositareallbornebytheemployer,buttheemployerdoesreceivethetaxbenefit.

Definedcontributionplansaremainlyeitherprofitsharingorso-calledsalaryreduction plans. Profit sharing plans have a promised pay-in based on apercentage of profits, but no guaranteed pay-in or benefit; they are mainlydesignedtodefertaxes.Profitsharingplansmustbeequitable;thatis,theydon'tpreferthehigher-levelemployees.Salaryreductionplansallowyoutosetasideincomeonapretaxbasis,withpossibleemployermatch.Thepopular401(k)isanexample.

Most notably, defined contributionplans shift all retirement funding risk toyou. What you accumulate depends on what is contributed and how it isinvested. There is no guarantee or obligation for the employer to pay aretirement benefit. As a consequence, the trend today is toward definedcontributionplans,shiftingresponsibilitytoyou.Theramificationsshouldn'tbeoverlooked.

Question101:Ihaveapensionplan.Isthereanythingtoworryabout?

Thebenefitpromiseprovidedbyatraditionalpensionplaniscertainlyattractiveas today's retirement plansmove away fromguaranteed benefits.However, asseeninindustrieslikesteelandairlines,evenapensionisnotcompletelysecureiftheemployerfailsinbusiness.Althoughbankruptcycourtsputahighpriorityonpensionpayouts,itispossibleforacompanytoterminateorreduceapensionplan in bankruptcy, or theymayunderfund it along theway,making eventualbankruptcy and default more likely. The good news: the government-backedPension Benefit Guarantee Corporation (PBGC) stands behind pensions inmuch the same way as the Federal Deposit Insurance Corporation (FDIC)stands behind bank and savings and loan deposits. This helps, but there isgrowingconcernthatevenPBGCwon'tbeabletomeetallobligations.Finally,you should pay attention to annual company pension statements tomake sureexpectedpayoutsarekeepingpacewithinflation.

Keep tabs on the business affairs of your employer, and don't depend toomuchonthepension.YoucanbuildotherretirementsavingswithIRAs—RothIRAs are probably best—and through normal savings and real estate equitybuildup.Oneother thing—pensionsmaybeguaranteed,buthealthbenefitsarenot.Manycompaniesarecuttingbackinthisimportantarea.

Question102:Areretirementsavingsplanstax-free?The short answer is “no.” Whether they are employer plans (pension, profitsharing, salary reduction) or individual (IRAs), most retirement savings plansdefertaxes; theydon'teliminatethemcompletely.That is, taxmaybedeferredonfundspaidin,causingashort-termreductionintaxliability.Buttheeventualwithdrawal of those funds is taxable.Thegoodnews:most are in a lower taxbracketinretirement,sothetaxbiteisless.Withthatsaid,manypeopleforgettoincorporatetaxesintotheirretirementplanningneeds.Thefundsyouwithdrawwillbetaxable.

The notable exception is Roth IRAs. Roth IRAs are funded with after-taxdollarsso thatdepositedfundscanbewithdrawntax-free—infactatany time,preretirementorpostretirement.Moreimportantly, theearningsonfundsintheaccount are also tax-free. This tax advantage combined with the unlimitedaccountretention(thatis,nomandatorywithdrawalsatageseventy-and-a-half),makeRothIRAsapowerfullong-termsavingstool.

Question103:Iplantoleavemycurrentposition.Whataremyretirementplanoptions,andwhichisbest?If you have been with your employer long enough with enough in yourretirementplan,youhaveachoicetoleaveyourretirementplanintactorto“rollitover”intoanother.Therolloverrulesarefairlycomplex,but ingeneral,youcan roll over any type of plan (profit sharing plan, 401[k] plan, lump sumcashoutof apensionplan) into a traditional orRoth IRA.Generallyyouhavesixty days to complete the rollover. There is some paperwork. It is not toocomplex,andmostreceivingfinancialinstitutionswillgladlyassistyou.

Assumingyou'reeligibletokeeptheplanintact,therolloverchoiceismainlya matter of personal preference. Many prefer to consolidate their retirementsavingsintoasingleplan,ratherthanscatteringaboutbitsandpieces.RolloverIRAs have more investment options; you aren't constrained by investmentchoicesasintheemployerplan.Youmayencountermodestfeesintherolloveraccount,butingeneralthereisnocostpenalty.Notethatyoucannotreversetherollovershouldyoudecidetoreturntothatemployer.

Question104:Mycompanyretirementplanhasanoptiontotakealumpsumatretirementorconverttoanannuity.Whichisbetter?Atoughchoicewithnoguidingrule,thisdecisiondependsonyourpreferencesandpayoutfeatures.Lump sumdistributions cash you out at a calculated accrued value of your

plan.Pensionplansdonot have assets individually taggedwithyournameonthem; they are a shared pool of assets. So the assumptions used to determineyour portion are important. A lump sum must be rolled over into anotherretirementvehicle(toavoidpayingtaxesonasingularhighamount).Howyouinvest the proceeds becomes important. Depending on the plan, buying anannuity on the open market might be attractive but be careful about highcommissions.

Annuity payouts are attractive for those expecting to live a long life(especiallyifit'sajointandsurvivorannuitycoveringyourspouseatyourdeath,that is, twopeoplehave todie toceasepayment).At theendof theday, it'sacomplexpros and cons analysis, so it's best to takeyour time, analyzepayout

alternativesclosely,andgetprofessionalhelp.

Question105:Howdo401(k)planswork,andwhyiseverybodysopositiveaboutthem?A401(k)planisasalarydeferralplan,whereacertainpercentageofyoursalarycanbesetasidebeforetaxesinacompany-sponsoredinvestmentplan.Themainattractions are the relatively large amount that can be set aside (for 2005, 17percentofsalaryupto$14,000/year),andmanycompaniesmatchyourdeferralupto3percentofyoursalary.Thecombinationoflargecontributions,companymatch, and tax-deferred growth can be powerful; with moderate investmentsuccess, it ispossible foraverageearners toaccumulate$1millionormore intheseplans.Forexample,awageearner(orhusband/wifecombination)earning$80,000/year and setting aside 10 percent with a 3 percent employer match($10,400/year), with a 7 percent return over thirty years (an accumulationannuityfactorof94.1),accumulates$978,640attheendofthethirtyyears.

Thehighgrowthpotentialisattractivetoemployees,andshiftinginvestmentrisktotheemployeeandadministrativesimplicityareattractivetotheemployer,hence the recent popularity. But employees accept the risk, and investmentchoices,whichmaybelimitedinsomeplans,areenormouslyimportant.

Question106:HowmuchcanIcontributetomy401(k)?Afterremainingconstantformanyyears,theIRSisgraduallyincreasingannualcontributionlimits.Asmentionedpreviously,for2005thelimitis17percentofsalary up to a maximum of $14,000/year (up from $11,000 in 2002); it isscheduledtoriseto$15,000by2006andbeadjustedforinflationthereafter.Aspecialprovisionallowsearnersagefiftyandovertodeferanextra$3,000/year,risingto$5,000/yearin2006.OntheWeb,www.401khelpcenter.com isagoodresourcetomonitor401(k)rules.

Question107:Myemployeroffersaseriesof401(k)investmentchoices.HowshouldIallocatemyinvestments?ShouldIrotatethemactively?

Particularlyconsideringtax-deferredreturns,401(k)investingchoicescanhaveamajorimpactonfuturewealth.Employersusuallyoutsourcethemanagementof 401(k) plans to a plan administrator; the administrator offers a series ofinvestmentchoiceswithemployeragreement.Thesechoicesusuallyconsistofaseriesofmutualfunds,oftenasetofin-houseadministratorfunds,Fidelitybeingacommonexample.The fundscovera rangeof investmentclasses from largecapstocks to international tobond funds.Usually there isanoffering trackingthe sharesof theemployer ifpublicly traded.Thevarietyof fundsofferedhasincreased in recent years, driven in part by concerns about mutual funds andoverexposuretoalimitedfewinvestments.

Therearenosetinvestingguidelines;however,itdoesmakesense,giventaxdeferral and the long-term nature of these plans, to weight toward growth-oriented investments.Thirtyyears in a short-termbondormoneymarket fundwon'tachieveyourinvestingobjectives,althoughitmightbeagoodsafehavenat times. Most advisors recommend staying the course, not doing too muchswitching,andavoidingoverweight—morethan20to30percentofholdings—inthecompany'sownshares.

Question108:I'veheardyoucan'twithdrawfundsfroma401(k)planbeforeage59½withoutincurringa10percentpenalty.Whataretheexceptions?Generallythisruleisright,buttherearesome“hardshipexceptions”:

Involuntaryjobterminationbeyondagefifty-fiveUnreimbursed medical costs exceeding 7.5 percent of adjusted grossincomeDivorceagreementshiftingfundstospouseordependentTotaldisabilityDeathandtransferofaccounttobeneficiary

Question109:WhatshouldIlookforinagood401(k)plan?The best 401 (k) plans have immediate eligibility, generous employeematch,easy administration (including account balance tracking, investment changes,

etc.), and quality investment choices. There should be at least ten to twelveinvestmentchoicesavailable;moreisbetter.Choicesshouldruntherangefrommoneymarketandbondfundstoconservativeandaggressiveequityfundsandshouldinclude“namebrand”mutualfundchoices.Expensesshouldbelow(lessthan1percent)or,betteryet,paidby theemployer.Better401 (k)planshaveadvisorsavailablebytelephone(usuallyemployedbytheplanadministrator)tohelpwithyourinvestmentchoicesandadministrativeissues.

Question110:Iwanttobuyahome,andIhaveheardthatIcanborrowagainstmy401(k)plantodoso.CanI,andisitagoodidea?Loans against 401(k) accounts are generally allowed by law but may berestrictedordisallowedbyyouremployer.Most401(k)plansallowborrowingofup to50percentof thevestedbalanceataplan-specified interest rate tobepaid back in five years.Many plans limit loans and can be only for qualifiededucational or medical expenses or to purchase a home. Attractively, interestpaidgoesintoyouraccount,nottoalender,andsuchloansavoidthe10percentwithdrawalpenalty.

Should401(k)loansbeusedtobuyahome?Probablynot.Whileinterestisrecapturedintoyourownaccount,therateisusuallyhigher.Mostloansareduein five years, so it fails as a long-term financing solution.More importantly,assetscommittedtotheloanarepulledoutoftheinvestmentpool,soyouloselong-termgrowthandcompoundingontheseassets.Finally,balancesaredueinfull upon termination (or else it becomes taxable income), bringing a nasty“doublewhammy”toyourfinances,ariskmostshouldn'ttake.Ifitrequiresyour401(k)tobuyahome,reevaluatethepurchase.

Question111:Iamaschoolteacher,andwehavea403(b)plan.Isthisdifferentfroma401(k)?How?403(b) plans are salarydeferral plans—much like 401(k)s—that are set up foruse by not-for-profit entities such schools, hospitals, public welfare agencies,and churches and church-affiliated organizations. Closely related 457 planscover many state and local government workers. The popular 401 (k) planactuallydescendedfromthe403(b).

Once hatched, 401 (k) plans evolved faster, allowing greater deferrals andinvestmentchoices.Butrecentlawchangeshavelet403(b)plansevolvetooffermany of the same provisions, including deferral limits and catch-upcontributions for fifty-plus earners. There is still another catch-up provisionoffered to certain employees with fifteen years of service, not available in401(k)s.Traditional403(b)plans limited investments to tax-deferredannuities;mostnowofferordinarymutualfunds.Like401(k)s,403(b)planscanberolledoverintootherretirementplansattermination.

Question112:HowmuchcanI/wecontributetoanIRA?Formanyyears,annualIRAcontributionswerelimitedto$2,000.Butattemptstobolsterindividualretirementsavinghavetriggeredaseriesofincreases.

For tax years 2002–04, contributions to all types of individual IRAs,includingRothIRAs,roseto$3,000.Thatlimitrisesto$4,000for2005–2007,and to $5,000 for 2008 and beyond. Additionally, beyond 2009 there is aprovision to increase limits according to an inflation index. Catch-upcontributionsallowanother$500eachyearforagefifty-plusworkers.

Besidestheselimits,therearealsomaximumcompensationlimitsforcertainIRAs. For Roth IRAs, full contributions are allowed up to a maximumcompensationof$150,000,phasingoutcompletelyat$160,000.TherearealsoincomelimitsandconditionstobesatisfiedtomaketraditionalIRAsdeductible—see Question 113 for more on this. There are no compensation limits fornondeductibletraditionalIRAs.

Question113:What'sthedifferencebetweenadeductibleandanondeductibleIRA?WhenareIRAsdeductible?Traditional IRAs are unconditionally deductible—that is, you can deduct yourannual contribution for income tax purposes if you don't participate in someotheremployer-sponsoredplan.Ifanemployeeparticipatesinaretirementplan(e.g., pension, profit sharing, 401[k] or other salary deferral), the IRS allowsdeductibleIRAsonlyiftheemployeefallsbelowcertainincomelimits.In2005,the limit is $50,000 with a phaseout at $60,000 for single filers. Employeesearning over $60,000 cannot deduct traditional IRA contributions but can stillmake them. For married couples both participating in employer plans, the

phaseout begins at $70,000 and ends at $80,000, with higher limits for thenonworkingspouseofaparticipatingemployee(seeQuestion114).RememberthatRothIRAsareneverdeductible.

Question114:WhatisaspousalIRA?Recent legislationmade it attractive to set up spousal IRAs, that is, IRAs fornonworking spouses of wage earners participating in their employers' plans.Without this provision, unemployed persons were generally not allowed tocontributetoIRAs.

Spousalprovisionsallowafulladditionalcontribution($4,000in2005,risingto$5,000in2008)foranyspouseaslongasreturnsarefiledas“marriedfilingjointly,” combined compensation does not exceed $160,000 ($150,000phaseout),andtheIRAissetup in theirownaccount. If thespouseworksbutdoesn't participate in an employer-sponsored plan (see Question 113), the$160,000 limit still applies. If the spouse does participate in an employer-sponsoredplan, the joint compensation limitdrops to$80,000 in2005 (withaphaseoutbeginningat$70,000).Aswithall IRAs,contributionscannotexceedgrossincomereportedonthereturn.

Spousal IRAs can be a powerful and often overlooked tool to sheltermoreincome and build still more retirement savings in many households. It alsoprovidesadegreeoffinancialsecuritytothenonworkingspouse.

Question115:WhatisaRothIRA,andhowisitbetterthanatraditionalIRA?RothIRAsaregenerallymorepowerful long-termsavings toolsfor threemainreasons:

1. Tax-free investment income. Earnings on traditional IRAs—whethercontributionsaredeductedornot—aretax-deferred;thatis,theyaretaxablewhenwithdrawn (usually during retirement). Roth earnings are tax free—period.

2.Contributions(notearnings)canbewithdrawnatanytimetax-andpenalty-freesincetheyweremadewithafter-taxdollars.

3.No required distributions.While one must start withdrawing (and payingtaxes) from traditional IRAs by age seventy-and-a-half, there is no suchrequirementforRothIRAs.Unusedfundscanberetainedtogrowfurtherforlaterretirementyearsortopasstoheirs.Further,contributionscancontinueindefinitely, while traditional IRA contributionsmust stop at age seventy-and-a-half Finally, accounts transferred to heirs at death are not taxableincome.SoRothIRAsareabettertooltobuildfamilywealth.

Roth IRA contributions can bemade even if participating in an employer-sponsoredplan(up toa$150,000to$160,000incomelimit).Theycanalsobeaddedto traditional IRAcontributions,subject to the$4,000(2005–2007) totalannual contribution limit. Generally, one should first contribute to employer-sponsoredplans(suchasa401[k])toenjoyemployercontributionsandmatch.RothIRAsareagoodplacetoputsavingsbeyondfamilyemergencyfundsandotheraccessiblesavings.

Question116:Ourcombinedfamilyincomeexceeds$170,000.CanweandshouldwestillcontributetoanIRA?Youcan'tcontributetoaRothIRAbecauseofthe$160,000compensationlimit,and you can't deduct a traditional IRA contribution if participating in anemployer-sponsored plan. That said, a nondeductible traditional IRA is still agoodidea,foritsetssavingsasideandistax-deferred.Soifothersavingsneedsaremet,includingcontributionstocompany-sponsoredplansmadesoastofullymaximizecompanymatch,nondeductibletraditionalIRAsarestillagoodidea.

Question117:WhereshouldIkeepandinvestmyIRAassets?Today every financial institution offers some formof IRA account, andmanyoffer an assortment. Banks, credit unions, mutual funds, and traditional anddiscountbrokeragesareallactiveintheIRAspace.

AsanIRAowner,youhaveachoicebetweenmanagedandself-directedIRAaccounts. Managed accounts have professional managers directing yourinvestments.Mostmutualfundcompaniesoffermanagedaccounts,andbrokersandnowsomebanksofferthem,too.Asthenameimplies,youpayfeesforthisservice,from$50/yearto1percentofassetamount,dependingonthesizeofthe

accountandthelevelofmanagementactivity.Minimumaccountsizesmaygetinthewayforsome.

Self-directed accounts are set up so that you choose and manage theinvestments. Such accounts are most often found at discount brokers. Mostaccounts have a small annual fee (usually $50 or less), although many nowwaive that feewith amodestminimumbalance.Somemayhave closing fees,and be sure to check the transaction commission rate.Many providers chargehighercommissionsthanforregular“street”accounts,andmanywillgiveyouadiscountedcommissiononyourIRAifyouhaveatraditionalstreetaccountwiththem.

Aswithmostinvestmentservices,shoptounderstandservicesandcostsandpickwhat'srightforyou.Don'tpayforwhatyoudon'tneed.

Question118:WhatkindsofinvestmentscanIuseforanIRA,andwhichinvestmentsarebest?Bydefinition,IRAsarelong-terminvestments,andsuccessisdrivenbysteadilycompounding growth over a long period of time. When one has many yearsbefore retirement, it makes sense to take a little more risk to achieve highergrowth rates. When one approaches retirement, one should get moreconservative so as to preserve assets in the event of a downturn. As a result,many investors choose to invest more aggressively during their most activeworkingyears,gradually shifting investments tomoreconservativevehicles inthetenyearsorsobeforeretirement.Aconvenientruleofthumbusedbymany:subtract your age from 100—that is the percentage of your IRA (or otherretirementaccount)toinvestaggressively.

IRA rules allow investment in almost anything except life insurance andcollectibles. Most invest in some combination of individual stocks, mutualfunds,andexchangetradedfunds.Again,steadyperformanceisgood,andsincealltaxesaredeferred,thetaxcharacteristicsofafunddonotmatter.Itmakesnosense to invest in tax-free vehicles (such as municipal bonds). Most fixedincomeinvestments,likeCDsormoneymarketfunds,don'tpayenoughtostayaheadofinflation.

Duringthewealth-accumulationyears,steady-performingstocksandgrowth-orientedmutual fundswith lowmanagement fees are usually considered best.Forthemostpart,theseinvestmentsshouldbeleftalonetoperformandgrow(if

theycan'tbe,youmayhavethewronginvestment).

Question119:Iammostcomfortablewithrealestateinvestments.DoIRAsandotherretirementplansallowdirectrealestateinvestments?Many people feel that real estate is the best long-term investment. Long-termperformance is attractive, and many people find it more understandable thanbusinessassets.Thatsaid—andsomewhatsurprisingly—itisrelativelydifficulttoplaceyourretirementassetsinrealestate.

Direct real estate investments (and investments in collectibles and othertangibles as well) are generally not allowed in 401 (k) and similar company-sponsoredplans.Youcannotbuythehousenextdoorforyour401(k).However,some securitized real estate investments are allowed, such as real estateinvestmenttrusts(REITs).Checktoseeifyouremployer-sponsoredplanoffersREITinvestmentsandthenevaluatetheREITcarefully.

Technically, all forms of real estate are allowed for IRAs, including directownership and limited partnerships. (Many securities brokers offering IRAsdon'twantyoutoknowthis.)ButyoucannotborrowmoneytofundanIRA;soyou must have enough assets to buy the properly outright. The rules arecomplex; normally such accounts are managed by specialized administratorswithhighfees.MostindividualsuseREITstogainrealestateexposure.

Question120:Iamself-employed.Whatretirementplansareavailable,andhowdoIchoosethebestone?Theshortanswer:self-employedpeoplehavemoreoptionstochoosefromthantypicalemployees,andmoreincomecanprobablybedeferredintotheplan.Thefour mainstream choices are SEP IRAs, SIMPLE plans, Keogh plans, andindividualIRAs.Aquickoverviewfollows.

SEPIRAsarepowerfultoolsthatallowyoutosaveupto25percentofyourdrawfromthebusiness,upto$41,000/year.TheyaresetupandmanagedsimilarlytoindividualIRAs,buttheplanmustalsoincludeemployees(notaproblemifyouhavenone).

SIMPLE, or Savings Incentive Match Plans for Employees, allow arelativelylargeemployeecontribution($9,000or$10,500ifyouarefiftyorolder)peryearplusan“employer”(upto3percent)match.SIMPLEplansaregood ifyouhaveemployees, formostof thecontributioncomesfromtheemployee'sownsalarydeferral.

Keogh plans are relatively complex but allow many forms of definedcontribution and defined benefit plans, including profit sharing, “moneypurchase”(whereapredeterminedamountistobesetaside),andtraditionalpensions. They are best where many employees and careful financialplanningareinvolvedandprofessionaladministrationisjustified.

Finally, individual IRAs can be used by self-employed people, either forsimplicitywheremodest contributions are desired ($4,000/year for 2005–2007pluscatch-upprovisions),oras“dessert”—toaddmoretoanexistingretirementarrangement.RothIRAsarepopularadd-ons.

The choices are complex; talk to a financial or tax professional beforechoosing.

Question121:IsthereatimewhereImustwithdrawfrommyIRAs?When,howmuch,andwhattaxes?TraditionalIRArulesrequireaminimumdistributionbeforeApril1oftheyearfollowing attainment of age seventy-and-a-half. The minimum amount isgovernedbyasetoffactorscorrespondingtoeachyearofagefromseventyon.For example, the factor for age seventy is 26.2, declining to 25.3 for ageseventy-one,24.4forageseventy-two,andsoforth.Therequireddistributioniscalculatedbydividingtheamountintheplanbythefactor;thustheownerofa$500,000IRAmust takea$19,084distribution($500,000/26.2)atageseventy$19,008 at age seventy-one ($480,916/25.3), etc. A stiff 50 percent of thecalculatedamountisappliedaspenaltytodistributionsrequiredbutnottaken.

IftheIRAwasadeductibleIRA,theentireamountistaxableattherecipient'scurrent income tax rate. If nondeductible, only the earnings are taxable. TheRothIRAprovidesthehappyexception.First,nodistributionisrequiredatall;second,alldistributionsaretax-free.

Question122:WhendomySocialSecuritybenefitsbecometaxable,andhowmuchtaxwillIpay?The rules are fairly complex and are designed to recapture taxes on SocialSecurity received beyond a certain amount of ordinary income. So if you arelivingonSocialSecurityonly,youwon'tbetaxed.

If you aremarried and earnmore than $32,000 ($25,000 single), includingone-halfofyourSocialSecuritybenefitsandotherwisenontaxablebondinterest(yes, it's complicated), your Social Security benefits may be taxed. Thepercentage of the Social Security that is taxable grows as the adjusted grossincomegrows.Amaximumof85percentofyourSocialSecurity is taxableat$44,000 joint ($35,000 single) in adjusted income. Income tax is then appliedbasedonyourbracket.Youdon'tlose85percentofyourSocialSecurity,nordoyoueverpaytaxon100percentofit.

Question123:WhathappensifIprematurelywithdrawfrommyIRAor401(k)?Generally youwill pay a 10 percent penalty plus all income taxes due on thetaxable portion of your withdrawal before age fifty-nine-and-a-half FordeductibleIRAs,thisistheentireamount.Ifyouhavetotake$50,000fromyourdeductibleIRAor401(k)andareina30percenttaxbracket(25percentfederal,5percentstate),youwillpaytaxesof$15,000andapenaltyof$5,000—asteepprice.

Hardship exceptions are available in IRAs and most 401 (k) plans fordisability,medical,andeducationalcostsandcostsofbuyingafirsthome.Thereisalsoaperiodicpaymentsprovisionsetupmainlyforprolongedunemploymentorearlyretirement.Anequalpaymentwithdrawaloveraperiodoftimecanbetaken from the accountwithout penalty as long as the payment ismaintaineduntil age fifty-nine-and-a-half (you must be fifty-five for 401[k]s). Note thattheseexceptionswaivethe10percentpenalty,butfundsreleasedarestillsubjecttotaxation.

Question124:Whatareannuities,andhowdotheywork?Annuitiesareahybridproductofinvestmentandinsurance,soldlikesecurities

byinsurancecompanies.Insomeways,theyarethereverseofinsurance;insteadofcollectingaperiodicpremiumupfrontagainstapossiblepayoff,theycollectalumpsumupfront against aperiodicpayout later.Most annuities are setup tobuywithalumpsum,oftenarolloverofretirementassets,topurchaseamonthlypayment streamforas longasyou (andsometimesyour spouse) live.Annuityassets grow on a tax-deferred basis, that is, they are allowed to compoundwithouttaxation.

Thevariationsandchoicesamongannuityproductsarevast.Youcanchoosedifferent forms of pay-in, investment, and payout. Pay-in options includeimmediate and deferred—the payment stream can start immediately, as inretirement, or can start several years later if you're young and want to buildsavings. The more conservative fixed annuities have a fixed payment tied tofixed income securities like bonds, usually with a minimum or “floor”guaranteed by the insurance company.Variable annuities have returns tied inpartorwhollytoastockmarketinvestmentportfolioandthushavegreaterrisk.

Payout options are complex. The simplest option gives payments throughyourlifetime,stoppingimmediatelyupondeath.Butwhatifyoudieonemonthafterannuitizing—starting—thepaymentstream?Topreventsuchacatastrophiclossofassetsforyourheirs,contractsarewrittenforperiodscertain, that is,aminimum of ten years, twenty years, or other guaranteed payments. Periodcertain and joint and survivor (where your spouse is entitled to continuedpaymentsuntildeath)arehandybutaddtothecostoftheannuity.

The chief downside to annuities is the cost. While few charge upfrontcommissions,manyhavehighsurrendercharges,upto10percent,foruptofive,seven, and even ten years after purchase. Fees and expenses can run ½ to 2percentperyear,alsoa largesum,and theremaybeothercharges.Purchasersmustunderstandallgivenandpotentialcosts.

Question125:Howmuchannuitycanyougetforyourmoney?Evenifannuitiesarenotforyou,itisusefultothinkaboutretirementinannuityterms. What lump sum amount do you need to support a regular retirementincomestream?Playingwiththenumbersisfunandinformative; theWebsitewww.immediateannuities.com provides an excellent tool. For instance, inCalifornia, a single annuity paying $2,000/month for life starting at age sixty-fivecosts$313,098.Addingaten-yearperiodcertainraisesthecostto$324,123,

and adding a joint and survivor provision with a 10-year period certain costs$378,268.

Notethatthesecalculationsreferto immediateannuities.Deferredannuitiescost lessbecause theyhave time togrow. Ingeneral, thehigher theprevailinginterest rates, the lower the initial lump sum required to support a particularpayment.Use the Internet toget familiarwithannuityproducts,but then it's agood idea to talk to a professional before buying. The cost of changing yourmindcanbequitehigh.

Question126:Whataretheprosandconsofannuities?Annuities are a combination of an investment and an insurance policy andcombinetheadvantagesanddisadvantagesofboth.

Advantages:

Guaranteedpayment.Onceanannuityispurchased,apaymentislockedin, although thepaymentmightvarydependingon the typeof annuity.TheguaranteemakesretirementplanningeasierInsuranceagainstlivingtoolong.Youmightplantolivefortwentyyearsinretirement,butwhatifyouliveforthirtyyears?It'shardtofindajobatageeighty-five.Mostannuitiespayforlife—whateverthatmaybe. Tax-deferred returns. Annuity earnings are taxed only when paid out,usuallyatlowertaxrates.

Disadvantages:

Highfeesandcosts,especiallyforearlysurrender.Riskofdyingtoosoonandnotgettingfullpotentialpayout.Inflationexposure.A$2,000/monthpaymentmightnotbuymuchtwentyyearsfromnow. Poor investment returns. Insurance companiesmustmake a profit andgenerally don't bring the best investment performance, especiallyconsidering fees. You may be better off investing on your own (evenwith mutual funds) and creating your own annuity, but that takesdiscipline.

Choosecarefullyandwatchoutforoverdonesalespitches.

Question127:Whatarereversemortgages,andhowcanIusetheminretirementplanning?Relatively new on the retirement planning scene, reverse mortgages can bepracticalforhomeownerswithsubstantialhomeequitywhowanttostayintheirhomes.Justasthenamesuggests,areversemortgagepaysyou,insteadofyoupayingthelender.Itcanbearegularpayment,oritcanbemanagedasacreditline,whereyouwithdrawasneeded.Asyouwithdraw,interestischargedontheamountpaidtoyouforthelifeof theloan.Effectively, thedebtonyourhomegrowsovertime(insteadofbeingreduced).Themortgageispaidoff,includingtheaccumulatedinterest,whenthehouseissold.

Inessence,areversemortgageworkslikeanannuity.Youpledgeanasset—your house—to receive regular payments. There are generally no taxconsequences, as payments generally consist of after-tax equity you alreadyown.Youmustbe sixty-two toget a reversemortgage, and thereare limits towhat you can borrow. For example, an owner of a $250,000 home can get athirty-year reversemortgage tied to $200,000 equity (the currentmaximum isabout $290,000 for any home value), which produces a monthly payment ofabout$600withamonthlyadjustableinterestrate.TheNationalReverseLoanMortgageAssociationprovidesagoodcalculatoratwww.reversemortgage.org,andmoregeneralinformationisavailablefromAARP(www.aarp.org/revmort).Thetermsarecomplexandbewareofhighfeesonloanorigination.

Question128:Canyousummarizeretirementplanningandsavingstrategy?Like all personal finance, successful retirement planning requires fundamentalawareness, commitment, and control. Retirement plans should be carefullyestablished, followed, and monitored for success. A few specific strategiesinclude:

Take advantage of available savings plans. There is a wide array of

individualandemployer-sponsoredplans,manyofwhichcanbeusedincombination. Increased contribution limits have made them morepowerfulrecently.Contributeasmuchas you can.The tax-deferred—and sometimes tax-free—status of savings plans is extremely attractive, especially if anemployer match is available. Such ability to leverage savings is rareelsewhere.Manageretirementassetsactively.Get thebestreturnsavailablewithariskyoucantolerate;don'tjustthrowitintoalow-payingCDormoneymarket fund. In retirement plans, the compounding concept enjoys nofinerhour.Payoffyourmortgage.Itmakesabigdifference(1)nothavingtofundthis debt and (2) being able to use home equity for retirement. It alsomakes a reverse mortgage or “downsizing”—selling the home andbuyinganannuitywiththeproceeds—possible.Plantosupplementretirementincome.Asmallamountofincomefromajob or part-time consultingwork goes a longway to stretch retirementassets;thementalactivityandbusy-nesshelpsinotherways,too.

Question129:Scenario:IamfiftyandknowI'veputoffsavingforretirement.Ijustspentalotonsendingmychildrentoschool.Myincomeis$85,000/year,butIonlyhave$25,000inretirementsavings.Iliveina$100,000homewitha$60,000mortgage.WhatshouldIdo?It'sobviousthatyou'rebehindinyourretirementsavings.

Thefirststepistocalculateyourgrossretirementneeds.Livingon75percentof current gross incomewould require $5,312/month in retirement.EstimatingSocial Security benefits is next. At current income levels, the Social SecurityAdministration estimates my benefit at about $1,650/month, leaving a netmonthly need of $3,662/month. Assuming a 20-year retirement and aninvestment return of 6 percent, the distribution annuity factor of 11.8 (SeeDistribution Annuity Table) indicates a required lump sum at retirement of$518,539($3,662/month×12months×11.8).

So, with $25,000 in savings with modest home equity, you're indeed far

behind.Itprobablymakessensetoconsiderdeferringretirementuntilageseventyif

you'reingoodhealth.Thatwillhelpinthreeways.First,the25percentincreaseinSocialSecuritypayments reduces the required lumpsumbyabout$58,000.Second,youhavefiveyearslongertosave(twentytotal,notfifteen),andthird,youmayonlyneed tocover fifteenyearsof retirement.That translates,witha9.7 factor for fifteen years (seeAccumulationAnnuityTable), to a new lumpsumrequirementof$378,241($5,312–S.S.of$2,062=$3,249/monthnetneed× 12 × 9.7). Now using accumulation annuitymath with a factor of 36.8 fortwentyyearsat6percent,youget anannual required savingsof$10,278.Theimplied12percentofincomesaved($10,278/$85,000)shouldn'tbetoodifficult,especially with employer match, tax benefits, and catch-up contributionprovisions.

Question130:Scenario:Iamfortyandreallywanttoretireearly.CanI?How?Myassetsareincome$80,000,home$250,000,mortgage$175,000at7.5percent,currentsavings$40,000,andretirementsavings$60,000.Thefirststepistodecidehowearlytoretire.Retirementbeforefifty-fivereallyputsaburdenonsavings,foryouneedtoplanatleastthirtyyearsofretirementand at least seven years without Social Security. You also need to considerhealth care and whether you can retire early from a job with some healthbenefits.

Without repeating thedetailedanalysisofQuestion129 (it ismoredetailedbecauseof theSocialSecurity issue), it's best to think in termsof a three-partstrategy.First,plantopayoffthehomebeforeyouretire.Thatimpliesa15-yearmortgage or shorter. Next, you should practice living cheap for two reasons:first,itwillhelplatertosurviveonsomethinglessthantheruleofthumbof70to 80 percent of current income, and second, because it allows some powersavings during the next fifteen years. Finally, those power savings should beinvested aggressivelywith the notion that, if successful, you can indeed retireearly;ifunfortunatelyyouarelesssuccessful,youstillhavesometimetobuildthenestegg.Thebottomlineispayoffthemortgage,learntolivefrugally,andstretchyourinvestmentsabit,andyouhaveashotatit.

H

Chapter10

ABOUTINVESTING

ow do you achieve life goals such as retirement, college, a newtelevision, or a bigger house? By accumulating wealth. How do youaccumulate wealth? Surely it starts with adequate savings. But it is

difficult to achieve financial independence on savings alone. To build asubstantialnestegg,thosesavingshavetowork,too.That“work”isinvesting—thedeploymentofcapitaltoachieveareturn.Thenatureofthatworkisunique,for it can feedon itself through theeffectsofcompounding.At theendof theday, investing is a powerful tool to achieve the wealth to whichmost peopleaspire.

The chief goals of investing are asset protection and asset growth. Thischapter explores investing basics and the many different paths to achievinginvestingobjectives.

Question131:Whyisinvestingsoimportantinpersonalfinance?Thegeneralmodelforbuildingwealthinpersonalfinancecanbesummarizedinthephrase“makeit,keepit,growit.”Investingisthegrowitpart.

In the long term, the income replacementmodel suggests that the power toearn through work declines over time, especially into retirement, and incomeneedsare supplied increasinglyby returnsonassets.So theamountof incomeyouhaveand,ultimately,yourlifestyledependontheamountofassetsyoucanaccumulate—yourgoldengoose.Itisthereturnsontheseassets—theeggs—thatproduce income. Investing is an important way to get ahead during workingyearsandtostayaheadduringretirement.

Question132:Ihavemysavingsinabank.Isthisinvesting?Technically“yes.”Yourmoneyissetaside,andit isearningareturn.But thatreturnmaybe1 to2percentdependingon the typeofaccount.With inflation

running approximately 3 percent, that money is actually losing purchasingpower. If it is being saved for college, where costs are escalating nearly 6percent annually, these savings are losingground.On theother hand, as thesesavingsareinsured, theinvestmentisverysafe.Youhaveachievedprotection,butnotgrowth.

Goodinvestingmeansdeployingyourcapitaltogrowfasterthaninflation.Itinvolves taking calculated risks to achieve these returns, requiring a degree ofcarefulmanagementeitherbyyouorafinancialprofessional.Long-termwealthbuilding requiresbeating inflationand riding thecompounding train toget themostoutofthatcapital.

Question133:PleasegiveasummaryofthemajorinvestmenttypesIneedtobefamiliarwith.Theinvestingworldiswide;hereisabriefsummary.

Stocks represent investments in businesses, that is, the deployment ofcapital to share in the returns of the business. “Sharing” can be throughreceiptofactualcashpayments—dividends—orbysharinginthegrowthofthe company as valued by the stock market. The stock market valuescompaniesthroughthecollectivevoiceofothersbuyingandsellingsharesinthecompany.

Bonds also represent investments in a business—orgovernment or publicagency—with apromiseof a specific return in a specific time.Corporatebond investors trade away participation in business success for thispromise.

Mutual funds are investment companies established to buy andmanage a“basket”of stocksand/orbondsonyourbehalf. Index funds are a specialtype of fund set up to track specific stock indexes such as the S&P 500,requiringrelativelyless(andlessexpensive)professionalmanagement.

Real estate investments can be direct, that is, in specific properties, orindirect,throughfundsdesignedtopurchaserealproperlyassets.

Commodities are raw materials, agricultural products, or key business

inputslikegold,oil,wheat,soybeans,orforeigncurrencies.Youcaninvestdirectly by buying gold or currencies, but it ismore practical to buy andsell.futurescontractsforfuturedeliveryofthesematerialsortobuystockinproducingcompanies.

Question134:Whatisthelong-termtrackrecordforthemajortypesofinvestments?Overthelongterm,stockshaveperformedthebestfortheactivemanagementofresourcesbyacorporateentity,andparticipationinthegrowthintheeconomyhasprevailed.Duringthepastseventy-fiveyears,stockshaveachievedaverageannual returns of about 11 percent but with significant year-to-year variation,especially in recent years. In that period, stocks achieved negative returns inabouttwenty-oneofthoseyears.Thatvolatilitysubsidesovertime;infact,innofifteen-year period since the 1920s have stocks produced a negative return.Corporatebondshaveachievedreturnsofabout6percentperyearwithlessthanhalf the volatility of stocks, and government bonds have achieved about 5percent with still less volatility. Real estate has performed about in line withstockswith less variability in overall annual performance. Because direct realestatepurchasescanbeleveragedwithdebt(mortgages),returnsformanyhavebeenhigher,buttherearealsomanagementcostsandtime.

Question135:Aretheregoodrulesabouthowtoallocatemyinvestmentsamongdifferenttypes?Age and risk tolerance are the two main factors governing allocation amongdifferent typesof investments.Asyougetolder, itbecomesmore important topreserve—rather than grow—the nest egg; so investments should shift towardthe relatively less volatile bonds, cash, and possibly income-producing realestate. Financial planners use a standard rule limiting “growth” (riskier)investments toafigureequal to100minusyourage.That is, ifyouare thirty-five,then65percentofyourassetsshouldbeinvestedaggressively;thatfiguredropsto40percentatagesixty.

Risktoleranceismoredifficulttoquantify,althoughmanyfinancialadvisorsattempttodosothroughsurveysandquestionnaires.Somepeoplepreferriskierinvestments to achieve the return; others just can't sleep at night. Riskier

investmentsrequireclosertrackingandmoretimespent.Yourownriskprofileis important,and ifyoucan't take the ideaof losing20percent inayear, thenstay away from individual stocks and aggressive small-companygrowth fundsthatcanlosethisamount.

Question136:Howactivelyinvolvedcan/shouldIbeinmanagingmyinvestments?Thisquestionhasreallycomeintothespotlightinrecentyearsasithasbecomemore apparent that many financial professionals—securities analysts, brokers,mutual fund managers—have acted more on their own behalf than for theirclients.The answer really depends on howmuch time you prefer and have tospend managing your investments. Even the most sophisticated investorsdelegate the management of some portion of their investments—maybe aretirementorcollegefund—toprofessionals.Thebestadviceistolearnasmuchas possible about investing and delegate wisely. Even if you bring inprofessionals, you need to follow what they're doing. Remember it's yourmoney.

Question137:Asaninvestor,itisobviousthatIneedtostayinformed.Whatarethebestbasicinformationsources?Driven inpart by technology, business change is accelerating relentlessly, andthefinancialmarketsthatfollowithavebecomemorevolatile.Unlessyouhavea financial advisorwhomyou trustwholeheartedly, you need to keep pace, atleast by reading the newspaper. More involved investors use financialnewspapers(TheWallStreetJournal, Investor'sBusinessDaily) tostayon topofbusinessandmarketplacetrends.Technology,whileacceleratingchange,alsoprovides a vast set of tools to keep track.Yahoo!Finance (finance.yahoo.com)andotherfinancialportalsdoanexcellentjobofbringingbusiness,market,andfinancialplanningtoolstogether.

Question138:Iamabeginninginvestor.ShouldIuseafull-servicebroker?

Brokerage houses provide awide range of services, from simple execution oftrades to varying degrees of “value-add” in the form of financial advice andresearchservices.Full-servicebrokerssuchasMerrillLynchandEdwardJonesofferadesignatedaccountmanagerforyouraccount,astaffofresearchanalysts,proprietary investment reportsandstock ratings,andother investing resources.Butyoupay;commissionscanbetentimesthatforadiscountbroker.DiscountbrokersmainlyoperatethroughtheInternetandtelephoneagenttrading,withanassortment of investing resources available. Most offer little in the way ofproprietaryinformationandindividualcoaching,butyoucanbuyandsellstocksforaslittleas$10pertrade.Theindustryismovingtoamiddlegroundwherecompanies like Charles Schwab offer assorted service options from straightInternettradingtoface-to-faceadvisoryservices.Someoftheseextraofferingsareavailableforfreeifyouhaveenoughinyouraccount.

To answer the question, full-service brokersmake sense if youplan to buyindividual stocks, have little time or interest in the markets, and wantpersonalizedadvice.Mostbrokersofferfinancialadvicebeyondinvestmentsbutbecarefulastheymaynotbefullytrainedorqualifiedtooffersuchadvice.Formore “do-it-yourself” oriented individuals, discount brokerage products areusuallyenough.Ifyouplanto investstrictly inmutualfunds,youdon'tneedabrokeratall;youcaninvestdirectlywiththefundcompany.

Question139:HowdoIchooseadiscountbroker?Televisionandnewspaperadvertisingispackedwithadsfordifferentbrokerageservices—discounterslikeE-Trade,Ameritrade,andWaterhouseSecuritiesandanassortmentoffull-servicebrokers.Discountbrokerscompetebyofferingfreetrades,shavingafewcentsfromcommissions,two-secondexecutionpromises,and availability of basic research materials such as Standard & Poor's stockreports. In reality there is little real difference, and the choice mostly comesdowntocustomerserviceandthesuitabilityofWebsitestoyourtaste.Canyouget goodphone support?Canyouget stockquotes andmake trades byphonewhen away from your normal workplace? Does their Web site meet yourexpectationsforeaseofuse?Agoodinvestmentideashouldbeagoodideatenseconds from now; so don't worry about execution speed. Remember, a goodinvestingstrategywithabadbrokerbeatsabadinvestingstrategywithagoodbroker.

Question140:Whatisthecaseforinvestinginindividualstocks?Whenyouinvestinstocks,youparticipateinthegrowthoftheU.S.economy.Ifyouchoose the rightcompanies, theywilloutpace theeconomy. In the longrun, owning corporate equities is the most proven way to beat inflation. Bybuying stock, you become an owner, employing professionals to generatesuperiorcashreturnsbybeingthebestintheirbusiness.

However, as has been so vividly demonstrated in recent years, it's hard toknow whether those professionals are really working for you (just think ofEnron,WorldCom,etc.)Itcanbequitedifficulttoferretoutthebestcompaniesin good businesses since the landscape changes constantly (for example,EastmanKodak,LucentTechnologies).Thebottomline:investinginindividualcompaniesbringsriskandalotofworkonyourparttosortouttheseissues.Themantra“riskbringsreward”appliesandviceversa.

Question141:Whatisthecaseforbondinvesting?With bonds, you lendmoney to a company to get a predetermined fixed andgenerally safe return on your investment. Bonds represent safely andpredictability;however,inmostmarketconditions,returnsaremodestandonlyslightly—2 to 3 percent—ahead of inflation. The bond investing world issomewhat mysterious and oriented to institutional and professional investors.Individual bond characteristics and credit risk information are hard to get andstill harder to interpret, and mistakes can be very costly. When buying andselling individual bonds, you should probably do so through a financialprofessional, which adds to the cost. Bond-oriented mutual funds are analternative,butcostsfurtherdilutereturns.Someformofbondorfixedincomeinvestmentisprobablyagoodideatoanchoraportfoliotoinsulateitfromstockmarket cycles. But there are alternatives such as dividend-paying stocks andpayingoffyourmortgage.

Question142:Whatisthecaseformutualfundinvesting?Mutual fundshavebeen themostpopularway for typicalU.S.households toinvest over the last forty years.With amutual fund, you essentially employ aprofessional manager and research resources of an investment company

(Putnam,T.RowePrice,Fidelity,etc.)toinvestforyou.Investorsseekinglessinvolvement and long-term performance find this attractive. Mutual fundsprovidediversificationthatindividualscan'tachieveandaregenerallysaferthanpursuingindividualinvestments.Mutualfundshaveconsumerizedtheirproductswithfriendlymarketingandcustomerservice.

There are downsides to fund investing. The first is cost. Professionalmanagementandmarketingexpensesarepassedontofund-holders,addingupto2 percent or more of a fund's value annually. Costs can seriously diluteperformance.Asaresult,some70to90percent(dependingonwhichstudyyouread)offundsunderperformthemarketasawhole.

Second,andcalledmoreintoquestionrecently,isthequalityandintegrityoffund management. Are they really working for you? The third is fundtransparency—it is hard to know how the fund is invested today and whatmanagement is really doing. Finally, by overtrading, some funds create taxsurprisesandtendtofurtherunderperforminthelongterm.Still,fundscanoffergoodvaluetoindividualinvestorsandcanaccomplishwhatmanycan'tordon'twanttodothemselves.Findingalternativefundswithlowerfeescanhelp.Indexfundsthattrackmajorstockmarketindices,reducingmanagementactivity,andthe recently arrived Exchange Traded Funds (ETFs) are worth a look—seeQuestion181.

Question143:Whatisthecaseforrealestateinvesting?Real estate has been a hot investment, particularly in the flat 2000–04 equitymarketperiod.Therecentboomhasbeenfueledbylowinterestrates,andsincemost real estate is boughtwith large loans (mortgages), that hasmade higherprices affordable. An influx of immigrants has fueled demand particularly incoastalareas.Realestateisattractivebecauseitistangible,andasinvestorsliketo say, “theyain'tmakinganymoreof it.”Appreciationhelps in resaleand toattract higher rents—cash flow—on investment properly during a longownershipperiod.Realestatehasproventobeagoodhedge—defense—againstinflation.Further,realestateistheonlyinvestmentwhereyoucanimprovevaluethroughyourownhardworkandingenuity.

Therearedownsides.Appreciationisbynomeansasurething;realestateisextremely sensitive to interest rates and location.People tend tounderestimatethetimeandcosttomaintainproperties.

Question144:Whatisthecaseforcommodityinvesting?Commodities are the raw materials and inputs to business and consumption.Logically, anything where demand is growing and supply is constant makessense to own as an investment. Such has been experienced with the recent“Chinaeffect”onindustrialinputs,especiallyoil.Commodities,especiallythosewithmoreconstrainedsupply,makesenseasahedgeagainstinflationandasa“globalization”play.

However,investingincommoditiesisverydifficult.Therearemanymarketforcesatplay,mostbeyondtheknowledgeandcomprehensionoftheindividualinvestor. “Constrainedsupply” tends tobecome lessconstrainedasprices rise;therearefew“surething”investments.Commoditieslikegold,owneddirectly,producenocashreturnsandmayinfactcostmoneytoown(storagecosts,etc).Most commodity investors use futures contracts, a very market-sensitive andtime-specific investment form. That is, you must be right about both whathappens andwhen it happens.Commodity investments requiremore time andexperiencethanmostinvestorshaveavailable.Investingincommodity-orientedbusinessessuchasmetal,timber,gold,oroilproducerscanbeagoodsubstitute,butcompanyperformanceinthatsectorcomesintoplay.

Question145:WhatisNASDAQ,andhowisitdifferentfromtheNYSE?NASDAQ and NYSE (NewYork Stock Exchange) are the two biggest stockmarkets,thatis,venueswhereindividualsanddealerscometogethertobuyandsell stocks. NASDAQ stands for National Association of Securities DealersAutomatedQuotations and is essentially a computerized bulletin boardwheredealersandsomeindividualscanpostquotes.Dealers,knownasmarketmakers,makemarkets for specific securities andmustpost quotations for abid—whattheywouldpayyouforastock,andanask, thepriceatwhichtheywouldsellyou the stock. Generally, your “buy” order is filled by themarketmakerwithsufficient shares available at the lowest quoted price on the electronic board.AdvancedLevel IIscreensmake itpossible toseequotes foralldealers in themarket.

UnlikeNASDAQ,whichisanalogoustothefreemarketcapitalismfoundinanyopenmarket, theNYSEissetupasanauctionmarket,whereallsalesarehandledbyanauctioneerknownasaspecialist.Thespecialistmatchesbuyand

sell orders and quotes the best bid and offer price for orders in hand or forpurchasesandsalesfromtheirowninventory.

Until recently, NYSE has been the elite marketplace for more establishedcompanies, while NASDAQ has flourished for younger growth-orientedcompanies. That is changing as theNYSE specialist system is questioned forfairness and as Internet technology brings NASDAQ transparency to morepeople.Formostinvestors,whetherastockisNYSElistedorNASDAQmakeslittledifference.

Question146:HowshouldIdecidewhethertoinvestinmutualfundsorindividualstocks?Basically individual stock investing requires two essential ingredients: moneyandtime.Moneymeanshavingsufficientfundstobuyenoughdifferentstockstoachievesomesafetythroughdiversificationandlargeenoughquantitiesofthosestocks to avoid excessive transaction costs. Markets set round lot purchasequantitiesof100sharesormore;anythinglessisknownasanoddlotandwillcostsomewhatmoretobuyandsell.Soyouneedenoughfundstobuyroundlotquantitiesinafew—atleastthreeorfour—companies.

More thanmoney, individual stock investing requires time, that is, time tounderstand thebusiness inwhichyouare investing.Thatmeansunderstandingthe marketplace in which the company sells its product and the company'sfinancial performance. Big companies are complex, and understanding thesefactors is no small task. It takes time and some business and financialknowledge.

For those just starting out or thosewho prefer to leave themanagement tosomeoneelse,mutualfundsorprofessionaladvisorsmaybeabetterbet.

Question147:MostmediastockmarketreportshighlighttheDowJonesIndustrialAverage.Isitstillagoodindicatorofmarketperformance?The“Dow”hasbeenaroundsinceabouttheturnofthelastcenturyandisstillthesimpleanswer to thequestion:“Whatdid themarketdo today?”TheDowJonesIndustrialAverage(DJIA)iscomprisedofthirtybluechip,ortop-quality,

stocks.Nottoolongago,theseweretrulyold-lineindustrialcompanieslikeU.S.Steel,GeneralMotors,Caterpillar, andGoodyearTire&Rubber.While someold names remain, recent changes have moved the group away from heavymanufacturingintosuchserviceandtechnologynamesasWal-Mart,Microsoft,Intel, and Johnson & Johnson. So the index today reflects a broader, moreservice-orientedeconomy.

TheDowisonlythirtycompanies,andittendstobethe“bluest”ofthebluechips.SomanymarketfollowerspreferthebroaderStandard&Poor's500StockIndex(S&P500).Whilethisindexbecameoverweightedwithtechnologynamesduringthelate1990sboom,today'scompanymixismorealignedtotheoveralleconomyandmarket.Fromits2000peaktomid-2004,theS&P500declined33percent,whiletheDJIAdeclinedabout16percent.Whichisabetterindicator?Youmakethecall.

Question148:Whatisastockreallyworth?This is a tough question, and the theoretical and practical answers are bothimportantfortheaverageinvestor.Thetheoreticalvalueofastockisthepresentvalueofallfuturecashreturnsfromthestock.Presentvaluemeansthatdollarsinhandtodayareworthmorethandollarsreceivedinthefuture.Soastockwith“predictable” cash returns occurring “sooner” is worth more. Future cashreturnsarenormallyfromearningsanddividendsbutcanbefromtheeventualsaleofallorpartofthecompany.Thetrickisdecidingwhetherpotentialfuturereturnsanduncertaintysurroundingthosereturnsareworthtoday'sprice.

The practical answer: a stock isworthwhatever the collective judgment ofmarket participants say it's worth, through actual purchases and sales of thestock.Themarketpricereflectsthiscollectivewisdom,which,attheendoftheday reflects the collective assessment of future cash returns—innormal times,anyway.Distorted perceptions or total ignorance of future cash returns causesmarket value to get away from real value,which iswhat happened in the late1990s.

Question149:Pleasecompareandcontrastgrowthandvalueinvesting.Growth investors seek growing companies in growing industries, usually

expecting 5 percent or more growth in revenues (and earnings) each year.Growthinvestmentsareusuallyfoundingrowthindustries,suchashightechorbiotech.Theymayalsobefoundintraditionalindustries,whereanewapproachor change in trends or tastes creates growth throughmarket share gains (e.g.,Starbucks in the restaurant/refreshment industry).Growth investors arewillingtopaymore for stocks thanworthbasedon today's returns (in fact,many losemoney)butarebettingonstrongfuturereturns.Valueinvestorslookforvalueinhandtoday—strongassets,lowdebt,strong

earningsandcashflows,dividends,andappreciablystrongmarketpositions intheirindustry.Theyareespeciallyattractedtosituationswherethesefactorsareunderestimatedbythemarket,thatis,wherethestocksellsatadiscounttorealvalue.Valueinvestorslookatastockasabusiness,buyingthestockasthoughtheywerebuyingthebusinessforthemselves,withallthediligencethatimplies.Valueinvestorsminimizeriskwithtangiblevalue;thatvalueprotectsthemfrommajordownsideswings.Theyalsolookforcompetitivebarriers,suchasastrongbrand,thatbuildprotective“moats”aroundthebusiness.

Recently the growth and value approaches have converged. Indeed, valueinvestors toowant toseegrowthpotential in thebusinessestheybuy,andtheyseek situations where that growth potential is undervalued in the market.“GrowthAtaReasonablePrice,”or“(GARP),”istheirinvestingmantra.Withinthis idea, even companies like Starbucks,with a strong brand and a 20 to 25percentannualgrowthrate,canbeconsideredavaluestock.

Question150:Ihearalotaboutdollar-costaveraging.Isthisjustabuzzword,orisitsomethingtoknowmoreabout?Dollar-costaveraging isoneof the fewbuzzword investingclichéscommonlyheardonAMradiofinancialshowsthathasrealandenduringmerit.Dollar-costaveragingisinvestingarelativelyfixedamountinamutualfund(orindividualstockorstockportfolio)overtime.Thewisdom:withaconstantinvestment,youbuyrelativelymoresharesduringdownturnsandrelativelyfewersharesduringperiods of strength. Thus, it serves to lower your average entry price into theinvestment, and it further serves as a regular savings vehicle. Of course, itdoesn'tguaranteesuccess—theinvestmentitselfmustberight,too,butyouwillenjoyimprovedperformanceevenwithamodestlyperforminginvestment.

Question151:Whatisaportfolio,andhowdoIbuildone?Aportfolio isacollectionof individualstocks,mutual funds,bonds,andotherinvestmentsbalancedtoachieveaninvestor'sobjectiveswhileminimizingrisk.A portfolio reduces risk by avoiding overconcentration—an “all-eggs-in-one-basket”approach—inasingleinvestment.Overconcentrationistemptingtonewinvestorsseekingto“hitahomerun”withanovelinvestingideaortoinvestorswithtoolittlemoneytoinvesttoachievediversification.

Typically,goodportfoliosfirstallocateassetsbetweenassetclasses—usuallystocks, bonds, real estate, and cash. The allocation percentage depends on aninvestor'sage,toleranceforrisk,andnear-termneeds,anditisafavoritetopicofmost financialadvisors.Withineachassetclass, theportfoliohasadiversifiedmixofstocks,bonds,andfunds.

Typically,adiversifiedstockorbondportfolioholdsfive to tencompanies,whileamutualfundportfoliomightholdthreetosevenfunds(fewerbecauseofthe diversification implied in funds). Funds are usually substituted when aninvestor has insufficient resources or knowledge to diversify with individualinvestments. While the risk of underdiversification is overexposure to thefortunesofasinglebusiness,thereisalsoariskofoverdiversification—thatis,spreading among toomany investments—and achieving at bestmarket returnswhileincurringexcessivecosts.Thebottomline:gethelpwhenyouneedit.

Question152:HowdoIselectastock?Thisisthe$64,000questionofinvesting—stockinvesting,anyway.Amongthethousandsofpubliclytradedissuestoselectfrom,howdoyougoaboutit?

The answer could fill an entire book. We'll choose the value investor'sapproach.Lookatthestockasashareinabusinessanddetermineifthebusinessiscongruenttoyourinvestingobjectives.

Part of the answer lies in your investing objective. Are you looking forrelativelycertaincash returns relatively soon, aswouldbe indicatedbyahighdividend? If so, your choices would likely include utilities and other staidinvestments with little growth, strong cash flow, and little risk. If, like moststockinvestors,you'relookingforabalanceofshort-termandlong-termreturnpotential,thebusinessvaluemodelcomesintoplay.

Valueinvestorslookforsituationswhereacompanyhasachievedstrongandgrowingmarketplaceposition,throughbrandexcellence,operationalexcellence,

proprietarytechnology,orsomeothersuperlativesetofattributesorskills.Next,they look for evidence that such marketplace excellence has translated intofinancial success—strong and growing profits, profit margins, cash flow, andreturn on deployed assets and stockholder's equity. Such a determination ishardly simple.This author's bookValue Investing forDummies (Wiley, 2002)goes deeper. Finally, once the business prospects are determined to be aboveaverage,theinvestorlooksforagoodprice—thatis,ashareprice—atwhichtobuy. It takes detailed research tomake the selection. For this answer, it's thethoughtprocessthat'simportant.

Question153:HowdoItellifabusiness(stock)isimprovingorhasdecliningprospects?This is another fundamental question for individual stock investors. Likeinvesting itself, assessing futureprospectsusuallymixesanalysis andcommonsense. The common sense part is sort of an ear-to-the-ground exercise. Is thecompany improving its products or services?Does themarketplace accept theproduct?Whatdopeoplesayabouttheproductonthestreetandinthepress?Dothecompanyanditsproductshaveapositiveornegativeimage?Istheproduct“in,” or is it a leftover of some gradually disappearing past? Contrast thefortunesofEastmanKodak,GeneralMotors,andHewlett-PackardwiththoseofStarbucks, Toyota, and Dell. One must be careful not to rely too much onpersonalopinionandnottogetcaughtupinfads.

Theanalyticalanswer involves reviewingcertainkey financials.Areprofitsimproving? How about profit margins? Are revenues increasing faster thancosts? How about productivity—the revenues and profits delivered per dollarinvested,perstoreowned,peremployee?Thelistofindicatorsislong,butintheend, theyall indicate thesortofexcellence—orlackthereof—discernedbythecommon-senseanalysis.

Question154:HowdoItellifastockisovervalued?There is no surefireway to tell if a stock is overvalued, formany stocks thatappear expensive relative to current performance have strong and oftenlegitimategrowthprospectsbuiltintotheirprices.

Most investorsgradestocksbytheirP/E (price-to-earningsratio),computed

bydividingthestockpricebythemostrecenttwelvemonths'reportedearnings.Recent historic average marketwide P/Es tend to range from about 16 to 23.Earningsyield,theinverseofP/E,isawaytomakesenseofthefigure.AP/Eof20 implies an earnings yield of 5 percent (1/20), a yardstick to compare toalternativeinvestments.

AddingmoreinformationisthePEG(Price/Earnings/Growthratio),relatingP/Etothegrowthrate.SoastockwithaP/Eof20anda20percentgrowthratehas aPEGof 1, an attractive level.But earnings are subject tomanyonetimefactors,manipulations,andspecial,noncashaccountingeventslikedepreciation.Asaresult,manyinvestorsareattractedtomorepuremeasuressuchasprice-to-cash-flow,butthatmayfailtoproperlyjudgecapitalinvestments.

In general, stocks appear overvalued if they have no significant earningsprospectsor if theP/E isgreater than25 (andespecially if thePEG isgreaterthan3).Althoughtheseratiosaregoodindicators,realanswersliedeeperinthefundamentalsofmarketplaceandfinancialperformance,wheremarketshareandprofitmarginscanbetelling.

Question155:Whatismeantbymarketcap,andwhyisitimportant?Market cap, or market capitalization, is the number of shares of a companyoutstandingmultipliedbytheshareprice.Soacompanywith100millionsharesoutstanding at a price of $20 has a market cap of $2 billion. Why is thisimportant?First,forthoseinvestinginastockasabusiness,marketcapgivesabig-pictureviewofbusinessvalue.IsStarbucksworth$18billionasacompany?IsCiscoworth$140billion?WasCiscoworth$500billionduringthebubble?Youbethejudge.

Marketcap isalsoused tosegmentcompaniesfor investing throughmutualfunds.Manymutualfundstarget“largecap”(>$5billion),“midcap”($1billionto$5billion),or“smallcap”(<$1billion)companies.Asaninvestor in thesefunds,you'llknowthekindsofcompaniesinwhichtheyinvest.

Question156:Ihaveitnow.WhendoIsellit?Thismaybethehardestquestionininvesting.Sellingishardtodo.Manymarrytheirinvestments,hopingthatthingsgobettersomedayevenifthingsarerotten

today.Likewise, somedump the investmentat the first signof trouble.What'stherightanswer?

There is, of course, no right answer, for there is no such thing as perfectbusinessjudgment.Thebestanswersare(1)sellwhenaninvestmentmeetsyourinvestingobjective(whichofcourseimpliesthatyousetaninvestingobjectiveinthefirstplace)and(2)sellwhenthereissomethingelsebettertobuy.Thosewhousebothoftheseprincipleswillusuallycomeoutahead.

Question157:Recentmarketvolatilityscaresme.WhatshouldIdoaboutit?Indeed,youhavereasonforconcern.Theincreasingpaceofglobalbusinessandeconomic change has causedmarkets to becomemore volatile. The S&P 500StockIndexhasclosedupordownmorethan10percentinnineofthelasttenyears, compared to only four times in the prior ten years. The NASDAQCompositeIndexhasbeenstillmorevolatile.Whatcanyoudo?

Expect it.Marketswill rise and fall; don't agonizeover each100-pointdropintheDowIndustrials.Prepareforit.Don'toverloadwithstockstoosensitivetoeconomicandmarketswings. Take advantage of it. Themore active investor uses downturns to buyvalue investmentsata lowerprice.Considerdownturnsanopportunity,notjustaproblem.

Question158:HowdoIdefendmyportfoliofromloss?Youcan'tprotectagainsteverything,for ifyoudidyouwouldalsodestroythepotentialforfuturegains.Butthereareafewwaystoprotectagainsttheworst.

Playdefense.Allocateportionsofyourportfoliotoinvestmentsrelativelyimmune to economic change, so-called defensive stocks like consumernondurables, food, and defense contractors. Bad times cause relativelylittledisruptionaspeopletendtobuyevenwhentheeconomicoutlookispoor.Globalinstabilitymayevenhelpdefensecontractors.

Diversify. While it may not help with global economic and marketdeclines, diversifying your investments helps defend against individualcompanyblowups.Buy“insurance.”Youcanbuy investment insurance in the formofputoptions(puts),givingyoutherighttosellsharesatacertainprice.Youcan also buy “puts” on market indexes like the S&P 500. Defensive-mindedinvestorsshouldlearnaboutthesetools.

Question159:Arestocksplitsagoodthing?Intheory,“no”;inpractice,“sometimes.”Withastocksplit,acompanysimplyexpands thenumberof sharesoutstandingaccording to the ratioof the split: acompanywith 100million shares selling at $40per share goes to 200millionsharesat$20per sharewitha2-for-1split.Haveyougainedanything?No. Ifyouhad100sharesat$40pershareandnowhave200sharesat$20pershare,youhavethesameinvestmentinthecompany.

However, stock splits are seen as a signal that management expectsimprovingbusinessprospectsandgrowthintheshareprice.Sotheremaybeapositiveinfluenceonmarketperception.Butasmarketssince2000havebecomemoredrivenbyvalue thanperception, this effecthas subsided in recentyears,andsplitsarelargelyanonevent.

Question160:Iamlookingattwocompanies,onepaysadividend,andtheotherdoesn't.Whichisthebetterinvestment?Withrecenttaxchangesfavoringdividends,thedebateonthissubjecthascomebackintothespotlight.Dividendsarecashreturns,usuallypaidoutofearnings,to shareholders as a return on their invested capital. Dividends are strictly amanagement decision, not a legal requirement. Companies that don't pay adividendsimplyreinvestearningsintothebusiness.

Some thinkdividends are abad signbecause companies are admitting theydon'thaveanythingbettertodowiththecapital.Thatis,therearenoavailableprojectsorbusinessesthatwouldproduceafavorablereturn,andsotheymayaswell distribute the funds to stockholders. Others hold thatmanagement teamsconcerned about shareholder interests arewilling to pay shareholders for theirinvestments. Recognizing shareholders and meeting business needs

simultaneouslyisasignofgoodmanagement.Today'sprudentinvestorislikelytoviewdividendsasagoodsignandenjoy

the favorable tax treatment aswell. The only exceptionwould be in a rapidlygrowingbusinesswithlargecapitalrequirements(thusrequiringreinvestment),butsuchcasesneedtobejustified.Noreinvestingwould-bedividendsinfancycorporatejets!

Question161:Whataretheprosandconsofbuyingstocksonmargin?Marginreferstofundsborrowedfromyourbrokertobuystocks.Investorscanset up amargin account relatively easily and borrow up to 50 percent of theamount of a new stockpurchase.Margin provides additional leverage, that is,more of an asset can be owned producing potentially higher returns on theinvested capital.Margin interest rates are competitive andmay be income taxdeductibleagainstearningsfromtheinvestment.

On the flip side,margin isdebt, likeanyotherdebt.The leverageworks inreverse if investments decline. That is, the asset may go away, but the debtdoesn't. In fact, if your equity declines below 35 percent of your investmentportfolio,youwillgetacall(amargincall)fromyourbrokerformorefunds.Onthewhole,marginismainlyforcarefulusebyexperiencedinvestors.

Question162:Ihearrecenttaxchangeshavefavoredinvestors.How?Startingin2003,themaximumfederalincometaxrateforbothlong-termcapitalgainsandqualifieddividendsis15percent.Priortothischange,dividendsweretaxedasordinaryincome,subjecttotaxratesupto35percent.Long-termcapitalgains—that is, for assets heldmore thanoneyear—were taxed at amaximumrate of 20 percent, and short-term gains were taxed as ordinary income. Thischangemakescertainkindsofinvestments,particularlydividend-payingstocks,muchmoreattractive.

Question163:Myunclesayshemakesalotofmoneysellingstocksshort.Canyoucommentonthisstrategy?

Short sellersmakemoney by borrowing shares from their brokers and sellingthem,hoping to buy themback later at a lowerprice.Obviously, short sellershope for market drops and declines in the fortunes of the companies they“short.”

When you sell short, you risk the possibility that the stock could go upindefinitely. This is the primary risk of short selling. Also, because of aDepression-erarule,shortsalesmustoccuronanuptick,thatis,animprovementfrom themost recent price,making it harder to jump on the bandwagon of astock already going down.Youmust see something others don't. Short sellersmustactivelymanagetheprogressoftheirinvestments,forlong-termexposuretoshortpositionsisrisky.Finally,borrowingsharescanbecostly;youhavetopaymargininterestratesandforanydividendslostbytheoriginalownerduringtheborrowingperiod.

With that said, many have done well by short selling, especially in recentyears.Shortsellingisagoodwaytoplaybothsidesofthemarketforinvestorsinclinedtowardshort-termopportunities.

Question164:Giveasummaryofthedifferentkindsofbondsandhowtheywouldbeusedindifferentportfolios.Bondscanbeclassifiedasfollows:

Governmentandcorporate—Governmentbondsincludefederal,state,andlocal governments and a variety of quasigovernmental agencies such astransit districts.Governmentbonds are relatively safe andusually at leastpartially tax-exempt but pay lower returns as a result. Corporate bondsgenerallypaymorebutaretaxableandmorerisky.

Taxable and tax-exempt—Manygovernment or agency bonds are exemptfrom some taxes. Municipal bonds, for instance, are federal tax exempt.U.S.Treasurysecuritiesareusuallyexemptfromlocalandstatetaxesandfederal-taxable only on a deferred (at maturity) basis. Tax-exempt bondsareattractivetohigh-incomeinvestors.

Investment grade and “junk” bonds—Investment grade bonds have beenjudged by credit agencies such as Standard& Poor's andMoody's to besolidcreditrisks;thatis,investorsaremostlikelytogettheircapitalrepaid.

“Junk”bondsentailmorecreditriskbutpayhigherrates,sometimesseveralpercentagepointshigher.

Short-term and long-term bonds—Short-term bonds are due (that is,principalisrepaid)usuallyinfiveyearsorless,whilelong-termbondscanbe ten, fifteen, thirtyoreven fortyyearsout.Long-termbonds lock inaninterestrate,butifthisrateisexceededbycurrentmarketconditions,itwilllosevalue.Short-termbondsarebetterforthoseseekingtopreservevaluebutusuallypaylowerinterestrates.

Question165:MyfriendtellsmethatIshouldinvestinbondsbecausetheyareriskfree.Isthisright?Whilebondsmaybringlessriskthanmoststocks,bondinvestingishardlyriskfree. Bonds comewith a promise that known amounts ofmoneywill be paidbackonspecificdates, thusreducingrisk.Nevertheless, there issomeriskthatthecompanyoragencywon'tbeable to repay,knownascredit risk.Only theU.S.Treasuryisgenerallyassumedtohavezerocreditrisk.Choosinghigh-gradecompaniesandagenciesreducescreditrisks.

Nextisinterestraterisk.Ifyoubuyabondpaying5percentandprevailinginterestratesriseto9percent,whathappenstothevalueofyourbond?Becauseabond investor todaycanbuya9percentbond,your5percentbond isworthless to them. So the market price of your bond declines accordingly, in fact,enoughtomakeyourbondpay9percenttothenewinvestor.

Finally,thereisinflationrisk.Risinginflationmeansthatprincipalpaidbackto you later has less purchasing power. The longer the time to maturity, thegreater the inflationandinterestraterisk.Morecanhappenduringlonger timeperiods,soinvestorsbuyshorter-termmaturities,payinglowerreturns,toavoidtheserisks.

Question166:HowdoItellifabondis“junk”?The quick answer: don't try to tell on your own! Credit risk analysis is verycomplex andbest left to themajor credit agencies such asStandard&Poor's,Moody's, and Fitch's. Standard& Poor's assigns grades of “BBB” and higher(BBB,A,AA,AAA)toinvestment-gradebonds;everything“BB”andloweris

junk. ForMoody's, investment grade is “Baa” and higher.Note that there aremanyshadesofjunk—D,C,CC,CCC,B,andBBontheS&Pscale;sotherearemany choices of risk/return profiles you can choose. The trick of junk bondinvesting is to make sure the additional return is worth the risk taken and todiversifyheavily—formostinvestorsthismeansinvestingthroughfunds.

Question167:HowcanIlearnmoreaboutspecificbondinvestments?Unfortunately,thebond-investingworldisfairlyopaqueandlargelyorientedtoinstitutional and fund investors. There are few easy sources of informationavailable about individual bonds. Internet financial portals such asYahoo!Financeprovidesomeverybasicbondinformationbutnotreallyenoughqualityorquantitytochooseandevaluatebondsinvestments.Investinginbonds—particularly individual bonds as opposed to bond funds—will likely have toworkthroughabrokerorfinancialprofessional.

Question168:Whicharebetter—taxablebondsortax-exemptbonds?Whenandwhy?Tax-exemptbondsareprimarilyattractive tohigher income investors.Whileagood quality corporate bondmay pay 5 or 6 percent, a comparablemunicipalbondmightpay4or5percent.Whichisthebetterchoice?Forinvestorsina30-percentcombinedtaxbracket,a5percentmunicipalyieldisroughlyequivalenttoa7-pluspercentcorporateyield.Someinvestorsare inahigher taxbracket.The bottom line: investors need to pencil it out for themselves, butmunicipalbondshavebeenattractiverecently.

Question169:GivemeacrashcourseonU.S.Treasurybonds.U.S.Treasurycreditinstrumentsareofferedinmanyvarieties,somemoreandsomelessorientedtoindividualconsumerinvestors:

Treasurybills,notes,andbondscanbepurchaseddirectlyorinsecondarymarkets in denominations of $1,000ormore.Billsmature in oneyear orless,notesmatureinonetotenyears,andbonds,reflectingarecentchange,

also mature in ten years (formerly thirty years). Interest rates typicallyincreasewithtimetomaturity,whilepriceswillfluctuatemore.

TreasuryInflationProtectionSecurities(TIPS)areanew,specializedtypeof note or bond paying nominal interest plus an amount indexed to thecurrent levelof inflation. Investors looking toeliminate inflation risk (seeQuestion 165) are attracted to these bonds with good reason; they are agoodcornerstoneinvestment.

Savingsbondsaretheconsumer-friendlyTreasuryproduct,boughtandsoldin increments as low as $25 from the Treasury or through local banks.Savingsbondsareboughtatadiscount—thatis,youpayareducedamountand redeem at face value. Some savings bond interest can be tax-free ifusedforeducation.

Treasury bond investors should visit the Treasury Direct Web site(www.treasurydirect.gov)tolearnmoreandbuydirectly.

Question170:I'mconcernedabouthowrisinginterestratesmightaffectmyportfolio.WhatshouldIdo?Risinginterestratesmakethebondsyouownlessattractive to investors in themarket so the value will decline, particularly if your bonds have a long timebeforereachingmaturity.Therearetwoapproachestoreducethisrisk.First,youcanshifttoshortermaturities,sacrificingsomereturn.Second,youcan“ladder”your portfolio, spreading bonds across many maturities—some maturing thisyear, some maturing next year, some maturing five years out, and so forth.Unfortunately, thisprocess ishard toachievewithsmallportfolios.Mostbondfundsemploythisstrategybutwatchoutforhighfeesandcosts.

Question171:Iliketheideaofinvestinginincome-producingsecurities,butI'mnotsurebondsareforme.Whataresomealternatives?Bondinvestingisthoughtbymanytobeboringandmysteriousandexpensiveaswell.Commissionsandfeescaneatuppotentialreturn,andcredit,interestrate,

andinflationrisksarehardtoeliminate.Payingoffamortgage,formost,isanintriguingalternative.Itisn'tinvesting

inthetraditionalsense,butitcanbelargelyequivalenttobuyingabondatyourmortgageinterestrate.Theinterestsavedisyourreturn,andtax-wiseitislargelyawash(youlosethemortgageinterestdeductionbutdon'tpaytaxesonthebondinterest). If you can't afford to pay off the whole mortgage, benefits aren'trealizedimmediatelybutaccrueasfutureinterestsavings.Butmostbond-relatedrisksgoaway.Liquidityfears—thatis,fearthatcashwillbetiedup—goawaywithtoday'seasyavailabilityofhomeequitycreditlines.

Otheralternatives includepreferredstocksandcertificatesofdeposit(CDs).Preferred stocks are like a bondbutwithnodefinitematurity andmore creditrisk. Like bonds, they are hard for consumer investors to evaluate. CDs areconveniently available at local financial institutions but pay low returns.Ordinary dividend-paying common stocks, especially with today's tax rules,havebecomemoreattractivebutbringrisksoftheirown.

Question172:Whataremutualfunds?Mutual funds are investment companies—companies formed for the specificpurposeof investingunder the InvestmentActof1940. Investment companiesmust pass through at least 90 percent of earnings to investors andmust haveseveral investment holdings. In return, investment company earnings aren'ttaxed. Mutual fund investment companies invest in a changeable mix ofsecurities, and they may be actively managed or follow an index. Unitinvestment trusts have a fixed set of investments at the beginning—oftensomethingbesides securities—andusually terminateat somepoint.Real estateinvestment trusts are an example. Finally, Exchange Traded Funds are anemerging hybrid, with some characteristics of mutual funds and somecharacteristicsofunitinvestmenttrusts.

Numbering over 9,200 today, conventional mutual funds have broughtinvesting to the consumer. They offer a value proposition of professionalmanagement, consumer-friendly information, access, and customer service alldeliveredforaprice.

Question173:Canyouelaborateonthecostsofmutualfund

investing?Manymutualfundshavecomeunderfirerecentlyforthesizeandcomplexityoftheir“pricetag”totheirinvestors.Fundsroutinelychargemanagementfeesforchoosing andmanaging holdings, ranging from 0.10 percent to 1.5 percent ormore of a fund's value. This doesn't sound likemuch until you add up totals,whichcanapproach$1billionforthelargestfunds,consideringonlyaminorityof funds outperforms the market. Further, funds charge 12-b-1 fees, passingthroughmarketing anddistribution costs up to 0.75percent (plus 0.25percentfor a service fee). It covers customer service costs and the commissions paidbrokersalespeopletoacquirenewinvestors.Soyoupayyourfundtobringotherinvestorsonboard.Finally, loadfundschargeinvestorsadirectcommissioninadditiontotheseotherfees,amountingtoasmuchas5percentandeffectivelylockinganinvestorinforfearofforfeitingthecommission.No-loadfundspullthesecostsfrominvestmentvalue.Asidefromloads,feesof1to3percentandsometimesmorecaneatabigchunkoftoday'smoreconservative6to8percentannual investment returns. Meanwhile, index and other inactively managedfundsmaychargehalfapercentorless.Fundinvestorsshouldchecktheexpenseratio—asummaryofallfees—anddecidewhetherthey'regettingvaluefortheirmoney.

Question174:Howshouldmostinvestorsusemutualfunds?Mutual funds are useful for those with limited resources and limited time tomanagetheirowninvestments.Investorswithlimitedassetscanstillparticipatein the largermarket. Investors lacking time orwho just don'twant tomanageinvestments can leave themanagement to someone else. In short, funds offereaseofentry,expertise,convenience,anddiversification.

Through professionallymanaged and balanced holdings,mutual funds helpinvestorsdiversifybydefinition.Fundsprovideapath to invest inchallengingsectors like international stocks and biotech, where expertise is beyond theaverageinvestor'sreach.Finally,fundsprovidetheprimaryvehicleforinvestingin many college savings plans (like so-called 529 plans) and are usually aneffectiveway to invest retirement assets for the long term.Most investors arewell served to have a mix of funds and individual investments, the mixdeterminedbypersonalpreferenceandinterestininvesting.

Question175:Ingeneral,howmanymutualfundsshouldIown?Theshortanswer:morethanonebutnottoomany.Itusuallymakesnosensetoownmorethanonefundinthesamecategory—forexample,twolargecapU.S.stockfunds.Why?Becausetheirinvestmentswilloverlap.Ifyouowntoomanyfunds, the resulting overdiversification costs a lot of money for a set ofinvestmentsunlikely todeviatemuchfromoverallmarketperformance.You'rebetter off to buy a low-cost index fund and walk away. A portfolio holdingsinglelargecap,smallcap,bond,andinternationalfundsmakesmoresense.

Question176:Whichisbetter—loadorno-loadfunds?Loadfundschargecommissionsofupto8percent(usuallyless)topurchasethefund. The load can be charged either up-front, upon sale, or sometime duringownership, and it is mainly paid as commission to the financial professionalsellingthefundwithaportionleftforadministration.Fourorfivepercenttakenout of your investment up-front is a hefty blow, taking a while to recoverthrough compounding.Many funds today prefer the no-load approach, wherecommissions are essentially pulled out of investment value.No-load funds dospread the impactacross timeandacrossmore investors,but theyare far fromtransparent. It ismore difficult to know exactlywhat the fund is charging itsinvestors.Generally,mostinvestorsarebetteroffwithno-loadfunds,butagoodloadfundisbetterthanabadno-loadfund.

Question177:FundlistingsinthenewspapershowClassA,B,andCsharesformanymutualfundgroups.Arethesegrades,orwhat?These letters do not represent grades, but rather load structure for load funds.“A” shares charge the load up-front with a smaller 12-b-1 marketing anddistribution fee and are themost common type. “B” shares charge a back-endredemptionfeeandahigher12-b-lfee,and“C”sharestypicallyspreadtheloadoverthefirstfewyearswitha12-b-landothermanagementfees.Whichisbest?The“A”approach takesabigcutup-front, takingmoney thatcouldotherwisegrow and compound off the table. The “B” approach is attractive because itdefers thisexpense,butsince theredemptionfee isapercentage,youmaypay

more later if the investment grows. The “C” approach is attractive because itspreadsthecost,butthecostsareoftenhigher.It'ssortofa“pickyourpoison”debate, and many investors choose to avoid the tough choice altogether bybuying no-load funds, which effectively spread costs over the course ofownership—thoughagain thesecostsmightbehigherandmight interferewiththepowerofcompounding.

Question178:Whatarethemajortaximplicationsofmutualfundinvesting?HowcanIavoidtaxsurprises?Mutualfundsarepass-throughentities, that is,realizedearningsandlossesarepassedthroughtobeaccountedforonyourownincometaxes.Incomereceivedin the form of dividends and interest on fund holdings are passed through asordinarydividend income toyou,asarecapitalgains realizedduring theyear.Unfortunately, most funds pass through their gains at the end of the year.Suppose you buy a fund in November that has realized a lot of gains in itsportfolioduringtheyear.Youwillpayahigherprice,ornetassetvalue,fortheshares,andyou'llalsobeaccountablefor thecapitalgainsrealizedthroughtheyear paid out at year end. Frequent buying and selling, or portfolio turnover,producesrealizedgains,andinvestorsseekingtoavoidcapitalgainstaxesseekfunds with low turnover. The good news: recent capital gains rate reductionshavereducedthetaxbite,andit'sanonissueforfundsusedinretirementortax-deferredcollegesavingsaccounts.

Question179:HowshouldIselectafund?Obviously, the answer is complex.The short answer: investors should look atfundobjectives,trackrecord,andexpenses.

The first step: do a fund's objectives and stylematch your goals?Growth,aggressive growth, value, income, “contrarian” performance opposite to themarket, or international exposure? There is no sure measure, but stated fundobjectivesandcorefundholdingshelp.Lookat thefundcompanyWebsiteoruse the Yahoo!Finance or Morningstar portals (finance.yahoo.com andwww.morningstar.com).

Performanceassessmentrunstwoways.Thefirstcomparestooverallmarketandsectorperformance; the secondcompares to risk.Checkhow the fundhas

performedagainst themajormarket indicesand, inparticular,againstasimilarbasketofstocks(largecapfundvs.alllargecapstocks).Morningstarcomparesperformancetopeergroupstocks;theseratingsappearinsomenewspapertables(theNewYorkTimes,forexample).

TheSharpe'sRatiocomparesperformancetofundvolatility,ariskmeasure,andcanbefoundinfinancialportalsmentionedpreviously.Thelowertheratio,thebetter.

Finally,youshould reviewcosts—allcosts—includingmanagement,12-b-l,operating, loads, and other. Most information sources gather these into anexpense ratio. Today's investing climate makes it imperative to get value foryourinvestingdollar.

Question180:Myfundcompanyhasreceivedbadpresslately.HowdoIdecideifit'stimetopullout?Recently uncoveredmutual fund scandals have hurt trust in what was once astaid, solid way for Americans to invest. Put simply, some mutual fundmanagers started to act for their own interest—and that of certain clients—inletting some trade the funds after hours and in other ways contrary to holderinterest.While harming trust, the effects aren't extensive and don't suggest animmediateexitfromthefundorfundcompany.Therealdecisioniswhetherthefund management is working for you and in your best interests. Goodperformance, open and honest management communications, and contritionfrom involved managers are all good signs. Still, if a fund or fund companymakes you nervous and you can changewithout substantial financial penalty,therearelotsofchoices.Simplyput,whyshouldyoulosesleepatnight?

Question181:Whatisanexchangetradedfund?Whataretheprosandcons?ExchangeTradedFunds(ETFs)arearapidlyemergingalternativetotraditionalmutual funds.Likemutual funds, they are investment pools set up tobuy andsell securities. But unlike mutual funds, shares are traded on regular stockexchanges,mostlytheAmericanStockExchange(NASDAQ/AMEX).Thereareabout140activelytradedETFstoday,andthenumberisgrowingrapidly.Someare set up to track U.S. and international stock indexes; some track specific

businesssectors(seeQuestion182).ETFs offer a convenient, inexpensive, and nimble way to diversify an

investmentportfolio.Theyoffervisibility.ItiseasytoviewETFholdings;onewayisthroughtheETFportalatYahoo!Finance(finance.yahoo.com).

Most ETFs aren't actively managed, and so you are more exposed to themovements of the market. They don't offer the customer service features ofmany mutual funds. However, some of the newer fund offerings are activelymanaged.

Question182:WhatkindsofETFsareavailable?ETFsaresetuptotrackvariousstockindicesorsectorsofthemarket,includinginternationalmarkets.IndexETFsare inactivelymanagedandsetupto trackamajorindex.Theever-more-popularStandard&Poor's500DepositoryReceipts(SPDR)andtheNASDAQ100Index(QQQ)ETFsareexamples.Theyofferaway to participate at minimal cost—a brokerage commission and expensesrunninglessthan0.20percentperyear.Sector ETFs track business sectors like energy, health care, or financial

services.Thesefundshavelimitedmanagementinselectingthetwentyorthirtylargest or most important stocks in the sector. Expenses are low, and thesevehiclesallowthesmallinvestortoplayinspecificsectorsoftheirchoiceandtorotate investments. It is likely that ETF choices will grow rapidly as thesimplicityandpopularityoftheseinvestmentsexpands.

Question183:HowshouldIuseETFsinmyportfolio?ETFs are a handy alternative to mutual funds. They allow large and smallinvestorstosetupallorpartoftheirportfoliototrackamarketormarketsector.With their low costs and visibility, ETFsmake sense as a low-risk “buy andhold” investment for small investors with limited funds to invest. For largerinvestors, ETFs are a way to tie part of a portfolio to market performance,allowingmore activemanagementof the rest of theportfolio.They are also ahandywaytogaininternationalexposureorrotateinvestmentsbetweenmarketsectorsfallinginandoutoffavor.Sincetheyarefundscontainingmanystocks,investorsarecautionedtobepatientforresults.

Question184:Describethedifferentwaystoinvestinrealestateandtheirprosandcons.The major ways to invest in real estate are direct investments, real estateinvestmenttrusts(REITs),andlimitedpartnerships.

Direct investments include buying your own residence or rental property.Such investments have a good track record for appreciation and give anopportunity to add sweat equity value but also can bring costs, timecommitments,andheadaches thatsomefail toanticipate.Theyare tied tospecificlocationsandarefarfromdiversified.

REITsare likemutual fundsspecializing inrealestate,usuallyasectorofthe real estate market like commercial, residential, rental property, orshopping centers. Some specialize in geographic regions. Like a mutualfund, you buy shares and capture returns as dividends or capital gains.Whilethesevehiclesofferaneasyandmorediversifiedwaytoinvest,youmay not know exactly what they own or how your money is beingmanaged.

Limited partnerships are equity ownerships in a specific portfolio of realestate, mainly tailored to larger investors looking for tax advantages inaddition to investment performance. They are beyond the scope of mostaverageinvestors.

Question185:Allmyfriendsseemtobemakingmoneywiththeirrealestateinvestments.Theybragabouteasygains.AmImissingsomethingorarethey?Driven by low interest rates, strong demand, low supply in keymarkets, andgainsinhouseholdformation,realestateindeedhasbeenagoodinvestmentinthepastfivetotenyears.Soyourfriendsprobablyhavemademoney.

Sincetheycanborrow80percentofthevalueandsometimesmore,therateof return on their invested capital may be especially high. A $200,000 houseboughtwith$40,000down,appreciatingto$300,000,suggestsa$100,000profiton $40,000, or a 250 percent return. This isworth bragging about, but it stillmust be looked at in full. Howmuch expense did they incurmaintaining the

properly, paying mortgage interest and taxes, finding tenants (for rentalproperty), and so forth?Howmuch risk did they take?How long did it take?Howmuchcapitalgainstaxwilltheypay,ifit'sarentalproperly?

The sober analysis: if theymade $100,000 “face value” on the properly ineightyears,with$20,000 in expenses and$12,000 in capital gains taxes, theyreallymade$68,000,or170percent.Onacompoundedgrowthbasis,thatworksoutto13percentperyear—notbadatall,butperhapsnotenoughtobethelifeofthecocktailparty.

Question186:Whatareequityoptions,andwhatshouldIknowaboutthem?Equityoptions are risk transfermechanismswhereownersof stockcan sellorbuy the right to acquire a stock by a fixed date at a fixed price.Call optionsallowanother investor tobuy that stock from themat a fixedpriceby a fixeddate;put options allow the investor to sell their stock to another investor at afixedpricebyafixeddate.Forthatright,thesellinginvestorcollectsapremium—thepriceoftheoption.

Ifaninvestorholds100sharesofXYZInc.,theycansellyoutherighttobuythose shares from them (a call), perhaps at $20 by the third Friday (the usualsettlementdate)ofApril.Ifthestockcurrentlyisat$19.25(“outofthemoney”),the premiummight be $1.00,meaning that each contract,which is to transfer100shares,bringstheinvestor(andcostsyou)$100.Thepremiumwillbemoreor less depending on the time to expiration, the current price of the stockcomparedtothestrikepriceof$20,andsharepricevolatility.

Calloptionsellersaregeneratingshort-termincomefromtheirholdingsattheexpenseofpotentialfuturegains;callbuyersaretryingtoachievebiggainsforrelatively small investments. Call sellers reduce risk by turning uncertainpotentialtocash;callbuyersrisklosingtheirpremium,butthatamountonly.Putbuyers insulate their portfolios against major downturns; put sellers are usingcash on the sidelines to generatemore cash and capitalize on overly negativefeelingsaboutastock.

Question187:Ithoughtalloptionplayswererisky.Rightorwrong?

Manypeopleimmediatelythink“risk”whentheyheartheword“option.”Butinfact, options can be used to reduce portfolio risk and generate certain cashagainst uncertainmarket performance.Sellingcovered call options at a higherstrikeprice—thatis,collectingapremiumforlettingsomeonebuyyourstockatapricehigherthantoday's—isagoodwaytocollectcash.Yougetthepremium,plustheadvancetothestrikeprice,attheexpenseoflosingpotentialforalargerbutstillmoreuncertaingain.Buyingputsonportfolioholdingsreducesriskofamajormarketdownturnorcompany“blowup,”butthistimeyouarepayingoutthecash—analogoustobuyinginsuranceonyourstockportfolio.Bothofthesetransactions reduce risk; selling covered calls has the additional advantage ofgeneratingcash,althoughthedownsideriskisstillthere.Themechanicsareabitcomplexandshouldbestudiedbyordinary investorsbefore jumping in.Thesetoolsareavailableandusedby“mainstreet”investors.

Question188:Scenario:Ihave$4,500toinvest.WhatshouldIdo?First, we must assume these savings are “free” to invest—that is, they aren'trequired as part of your day-to-day finances or emergency fund. Further, let'sassume these assets are outside your retirement plan, which, if a 401(k)-styleplan,hasitsownsetofspecificinvestmentchoices.

Theamountinvolvedmaybeenoughtojustifysettingupabrokerageaccountbutbecarefulaboutfeesandminimumbalances.Throughadiscountbrokerageaccount (youdon't have enough to interest a full-servicebroker), you canbuyindividual stocks,mutual funds, or exchange traded funds. ETFs are probablythebestchoiceinthisscenario,fortheyoffermarketperformancewithrelativelylow costs and allow some foray into specific business sectors, such as healthcare, technology, or even more aggressive biotech investments. With thisamount, it may make sense to stick with a broader market ETF, such as theSPDR (S&P 500) fund. If you are young and looking for more aggressivegrowthwith the risk that entails, one of themore “sexy,” or dynamic, sectorsmakes sense, and youmay have enough for two separate funds, probably notmore.Individualstocksprobablydon'tmakesenseatthispoint.

The other alternative is to invest directly with a mutual fund family,eliminating brokerage costs and providing the fund switching and customerserviceyoumightneed.Mutualfundsoffermonthlypaymentplans,helpingyousaveandgrowyourasset.

Question189:Scenario:Iamathirty-year-oldnoviceinvestorwith$50,000toinvest,mostlyfrompersonalsavingsandasmallinheritance.WhereshouldIinvest,andwhatshouldIavoid?You're in good position to start building an investment base, if you haven'talready.At thispoint in life, some liquidity is important—three to sixmonths'salaryorso,butyoucanaffordto invest themajorityfor the longterm.Beingyoung,youcanaffordtotakesomerisk.

You should think in termsof a portfoliowith some “base”market-trackinginvestmentslikeETFs,mutualfunds,or“bluechip”dividend-payingstocks.Tothat,youmightaddsomeindividualstockschosentocapitalizeongrowth-for-value opportunities. The mix of these investments depends in part on howactivelyyouwishtomanageyourportfolio.

There are at least two things to avoid. One is overconcentration in youremployer's own shares or even in the same industry, a common mistake in401(k) plans. A downturn can hit you twice. Also, at this stage, most bondinvestments don't make sense, as inflation tempers returns. If you're not yetcomfortableasaninvestor,it'sagoodtimetolearn,andyoumightwanttouseanadvisororfindadiscountbrokerofferingsomeadvice,atleastfortheshortterm.

Question190:Scenario:Ihave$100,000invested,mainlyinlong-termgrowthstocksandindexfunds.Imaybeheadedforaperiodofincomeinstability.HowdoIrebalancemyportfoliotogeneratemoreincome?This is the sort of switch many investors need to make during different lifestages—either toprotect incomeorprovide for college educationand the like.Thefirststepistoreframeinvestingobjectives.Mostinvestorsinthisclasswant8to10percentreturnsforthelongtermandevenmoreandarewillingtoforegocurrent returns and take more risk to get there. The new objective requiresdownsizedexpectations—for instance, to5 to7percentperyear—andplayingthegametomeetorslightlyexceedmarketperformance.Therearemanywaystodothis;hereareafew:

Keepa“core”portfoliototrackmajormarketindexes—inthatway,you

maintainatleastsomemarketparticipation. Look for a few dividend-paying, value-oriented stocks still preservingsomegrowthpotential.Bankstocksmightbeagoodexample. Learn to sell covered call options on some of your individual stockinvestmentstogenerateshort-termcash.YoucanalsosellS&P500andother index calls to generate cash.Readup on andpractice this beforeventuringtoodeep,andabrokeroradvisorfamiliarwiththesetoolscanhelp.

PARTIII

KeepingtheShiponCourse:AvoidingFinancialSurprises

N

Chapter11

PROTECTINGLIFEANDHEALTH

owweswitchgears fromcreatingandgrowingwealth toprotecting it.Nothingcanderail thewealthtrainfasterthanunexpected,catastrophicevents that wipe out the assets or income supporting you and your

future. The possibility of adverse events is risk, and the practice of guardingagainstriskisriskmanagement.

Riskmanagementimpliesplanningforalltypesofrisk.Yes,there'sariskthatyour bagel toastermight break—what do you do?Youmay decide to buy anextendedwarranty—insurance—butwhy?Youcansimply replace itorabsorbtherisk.Youmayreduceriskbyusingitlessoftenoravoidriskbynothavingitatall.Similarly,inlife,youmayreduceriskbywearingseatbeltsandavoidriskby not going skydiving. Although reducing and avoiding risks might prolongyour life, there is no guarantee that something won't happen. If it does, it isindeedacatastrophe—financiallyandotherwise.Forsuchbigrisksthatyoucan'teliminate,youtransfertherisk—thatis,buyinsurance.Thischaptercoversrisk-transferring insurance for life, health, and ability to produce income, whileChapter12coversinsuranceforthemajorassetsinyourlife—yourproperly.

Question191:WhyshouldIbuylifeinsurance?Themostobviousreasonistoprotectthefinancesofyourfamilyorhouseholdincaseofyouruntimelydemise. Ifyoudie early, expenseswill continue, andlargeobligationssuchasmortgagesstillneedtobemet.Obligationsmayevenincrease.What if you were the only earner receiving family health insurancecoveragethroughyouremployer?Thatwillneedtobereplaced,too.

Another reason to buy insurance today, even if you don't have a family to

protect, is to insure future insurance availability if your health declines. Youmust be in good health to qualify for some policies or to get preferred rates.Buyingapermanentpolicytodayguaranteeshavinginsurancetomorrow.Takingadvantage of employer group plans requires no physical examination now orlater—eventoincreasetheinsuredamount.Termpoliciescanbeboughtforlongcoverage periods; it is easier to renew policies than to start from scratch. Ingeneral, it'sgood to“getunder theumbrella,”buying insuranceyoumightnotneedthisminute.

Question192:HowmuchlifeinsurancedoIneed?Most financialadvisorsuse twoapproaches todetermine insuranceneeds.Theobligationsapproachmeasureshowmuchyourhouseholdwillneedtocarryon—housing,expenses,big-ticketitems,collegeexpenses,andotherspecialneeds.Futureincomepotentialfromremainingfamilymembersissubtractedtoarriveat an insured amount. The income replacement approach estimates howmuchincomeyouwouldhaveproducedifstillaliveadjustedfortimevalueofmoney.Bothapproachesarecomplicatedbutvalid.

As a simple rule of thumb, most advisors recommend insuring income-producingfamilymembersforabouttentimestheirannualincomeasastartingpoint. Other factors may suggest greater or lesser need, for instance, assetsownedorspecialexpenses.

Question193:Whataretheadvantagesofgrouplifeinsurance?Group life insurance is typically offered through employers or professionalorganizations.Asthenameimplies,theinsurancecompanylooksattheinsuredas a pool, not individuals, and rates the policy accordingly.Thismeans lowerrates since administrative costs are less. Moreover, you don't have to qualifyindividually for the insurance.The group rate already assumes somehigh-riskindividualsare in thegroupso that the insurancecompanydoesn't spendextramoneytocheckeveryoneout.Thismeansthatyoudofarlesstoqualifyfortheinsurance; there is no physical exam, for instance.Most groups allow addingcoveragewheneveryouwant,stillwithspecificqualificationwaived.Sogrouppolicieshaveadvantages,especiallyforhigh-riskindividuals.

Question194:WhatdifferenttypesoflifeinsurancecanIbuy?The twomain typesof life insuranceare term andpermanent.Term insurancelastsforadefinedperiodoftime;youpaypremiumsoverthistimeandreceiveadefinedbenefit upondeath. Ifyoudon't dieduring the termperiod, thepolicysimply goes away. Term insurance is typically available for one-, five-, ten-,fifteen-, and twenty-year periods.Level termpolicies spread premiums evenlythrough the term insteadof raisingpremiumseachyear according tomortalityrisk.Permanent insurance,oncebought, lastsuntilyoudie,whenever thatmight

be.Permanentinsurancepaysadefinedamountupondeathbutalsoaccumulatescash value for each year you don't die; it is actually an asset in addition tocoverage.Permanentinsurancecomesinwholelife,universallife,andvariableuniversal lifeforms.Wholelife, themostbasicform,requiresafixedpremiumpayment for a defined number of years with a predefined cash valueaccumulation.Universal life isa formofwhole lifeallowingflexiblepremiumpayments;yourcashvalueanddeathbenefitvaryaccordingtohowmuchispaidin.Variableuniversallifeincorporatesaninvestmentcomponent:cashvalueanddeathbenefitsvaryaccordingtoyourpaymentsandinvestmentperformance.

Question195:DoIbuytermorpermanentinsurance?Thisisacommondebateinpersonalfinance.Doyoubuyterminsurance,simplyproviding coverage, or go for themore expensive permanent insurance?Terminsuranceprovidescoverageonlyforthedefinedperiodandisprotectioninitsmostpureform.Itrequiressignificantlylowercashoutlays.Forthosewhoneedcoverageandcoverageonly,terminsuranceisusuallyenough.

Butwhathappenswhenthetermisover?Ifyoubuyatwenty-yearleveltermpolicy at age thirty-five, you'll get good coverage until age fifty-five. Thenyou're back into the insurance market again, facing several times as much inpremiums.Worseyet,yourhealthmayhavedeterioratedsothatyoumaynotbeinsurableatall.Youhaveaccumulatednocashvalue;thosepremiumsyoupaidaregone.

Theseare the typical argumentsofferedby insuranceagents andpermanentinsurance proponents. Permanent insurance is just that—it is permanent. Youneverhavetoqualifyagainforinsurance,andpremiumsdon'trise.Further,youaccumulatecashvalue,ahandyforcedsavingstoolformanypeople.Butcareful

analysisusuallyrevealsthattheassetaccumulationpartofpermanentinsurancedoesn't accumulate assets as fast as you can through normal investing.Why?Because somethingmust be set aside to cover death benefits, not to mentionagent commissions and other expenses. Term proponents recommend buyingterminsuranceandinvestingthepremiumdifferenceseparately.

Who's right? It reallydependsonyour situation. Ifyou'rehealthyandhaveinsurance needs that really last only a defined amount of time, the “term +investing” approach is probably better. You simply may not need so muchinsurancecoverageonceyourchildrenaregrown,otherassetsareaccumulated,andyourhomeispaidoff.

The bottom line: insure the need and don't get caught by tempting salespitches.

Question196:Whatisthebestwaytobuylifeinsurance?Thebestwaytobuylifeinsuranceisusuallythroughyouremployer,ifthereisagroup plan available. If no insurance benefit is available or if youwantmoreinsurance,therearetwochoices:buyfromaninsuranceagentorbuyonline.

Because of its investment features, permanent insurance forms (whole life,universal,orvariableuniversallife)areonlyofferedthroughlicensedinsuranceprofessionals; theseproducts aren't availableonline.Choosinganagent canbetricky. There are a lot of “sharks” out there attracted by the lure of highcommissions,anditisusuallyavery“salesy”experience.Findanagentyoucantrustthroughapersonalreferralorfinancialadvisorandmakesuretheytakethetime to explain the features and benefits of each policy clearly and inunderstandableterms.

Term insurance buyers find the Internet attractive if armed with a littleknowledge (if not, most insurer Web sites offer good educational materials).Web insurance portals like SelectQuote (www.selectquote.com) and Insweb(www.insweb.com)givehandy,easy-to-navigatecomparativequotesfromhigh-gradecompaniesandoffermodestpremiumsavings.Ofcourse,terminsuranceisalsoavailablethroughyourinsuranceagent.

Question197:Myinsuranceagenttalksaboutadd-on“riders”tolifepolicies.Igeteasilyconfusedbythejargonandbuzzwords.

WhatdoIreallyneedtoknow?Mostlikelyyou'veheardaboutsomeorallofthefollowing.

Renew ability. Some term life policies—and importantly, health anddisabilitypolicies—offerguaranteedrenewability.Thatis,youcanrenewregardlessofchanges inyourhealth—valuable ifconcernedaboutyourlong-termhealth.Premiumwaiver.Ifyoubecomeincapacitatedorchronicallyill, thelastthing you want is unpaid insurance bills hanging over your head.Premiumwaivers stop premiums under certain conditions, thoughmayaddmorethanyou'dliketoyourbill.Convertibility.Sometermpoliciescanbechangedtopermanentforms,awayofguaranteeingrenewabilityandusefulifyourfinancialsituationorneedschange.Typically,itcanonlybedoneduringthefirstfewyearsofaterm. Accidental death coverage adds additional benefits if your death is anaccident. There may also be benefits for partial disability ordismemberment.

Although these features sound nice, their costmust be evaluated rationallyagainstthebasepremiumcostandagainstotherwaystoprotectagainsttherisk.Aswithcars,suchoptionsareoftenmoreprofitablefortheinsurancecompanyandlucrativeforagents.

Question198:ShouldIconsiderbuyinglifeinsuranceformychildren?Many insurance agents suggest policies for children, and indeed the lowpremiumsdrivenbylowmortalityriskarecompelling.Forpermanentinsurancebuyers,it'sawaytogetstartedearly.

Somemay feel the loss of a child can bemade a tiny bit less painful by asubstantialinsurancepayment.Butreally,thereisnofinancialneed;infact,theloss of a child reduces financial requirements. There is simply no financialjustification tobuy term insurance forachild.As forpermanent insurance, it'sprobablybettertoinvestseparatelytotakeadvantageofthelongcompounding

period.

Question199:Ingeneral,whatarethetaximplicationsoflifeinsurance?Whendisasterstrikes, itprovidesat leastadegreeofcomfort toknowthat thebenefitcheckarrivesquicklyandiscompletelyincome-taxfree.Why?Becausepremiumswerepaidwithafter-taxdollars;sotaxeshaveessentiallyalreadybeenpaid.However,insuranceproceedsaretaxableforestatetaxpurposesunlesstheinsurancepolicyhasbeen transferred into a special insurance trust (thedetailsare beyond our scope here—ask your advisor). As estate tax exemptions aregrowing,suchtaxdoesn'taffectmany.

Earningsonpermanentinsuranceformsaretaxableonlyonadeferredbasis.Earnings compound favorably without taxation. This makes such policies,particularly stock-market-driven variable universal life policies, attractive forsome investors. Thosewho have sufficient income and havemaximized otherretirement-plancontributionsmightconsidervariableuniversal lifeasawaytoaddtotax-deferredretirementsavings.

Question200:Whatfactorsdrivelifeinsurancecost?IfIhavehighriskfactors,whatshouldIdo?Life insurance premiums are driven by age, health, habits, and family history.Theimpactofageisobvious.Accordingtomortalitytablesusedintheinsuranceindustry,atagetwenty-fiveapproximatelytwomales(onefemale)per1,000die,rising to four (four also for females) at age forty-five; twenty-five (fifteenfemales) at age sixty-five; 152 (116 females) at age eighty-five. So, purecoveragetermpremiumsexpanddramaticallyasyougetolder.

Insurance companies usually offerpreferred, standard, andhigh-risk rates.Health, habits, and family history become important in classifying individualpolicies. Smokerswill paymore, and physical examination results play a keyrole. Family history—both parents dying before sixty of natural causes, forexample—cancauselossofpreferredstatus.Thedifferencebetweenpreferred,standard,andhigh-riskratesislarge;afallfrompreferredtostandardcandoubleterm life insurance rates. People with high risk factors should look forcompaniesmoretolerantofthoseriskfactors.Insurersviewdifferenthealthrisks

andespeciallymorenebulousfactorslikefamilyhistorydifferently.

Question201:Isthechoiceoflifeinsurancecompaniesimportant?TheTVadsareallcompelling—ownapieceof therock,etc.Mostcompaniesoffer largely the same assortment of term and permanent insurance products.Some may offer slightly different features, and it is worthwhile to shop forpremiums.Manynowofferotherinvestmentproductsandadvice.Butthecorequestionis:willtheybearoundfiftyyearsfromnowwhenyouwanttocashoutyour permanent insurance policy?Will theybe able to pay a claim easily andquicklytenyearsfromnowwhenyourfamilysobadlyneedsit?

Insurancecompaniesshouldbejudgedbytheirpermanence,whichtranslatestofinancialstability,andtoanextent,fortheircustomerservice.Fortunately,itis relativelyeasy toassessstability;a ratingserviceknownasA.M.Best ratescompanieson anA/B/C/D scale.These ratings are relatively easy to find, andyou should look for “A” and better companies. Customer service is morenebulousbutstartswithyouragent.Isyouragenthelpfulandcooperative?Areexplanationseasytogetandunderstandable?Areyoucomfortable?Thispartisajudgmentcall.

Question202:Whataresomeofthedisadvantagesinbuyingwholeoruniversallife?The decision to buy any type of permanent insurance should be approachedcarefully,foritis,well,permanent.Perhapsnotcompletely,foryoucancashoutof a policy and stop paying premiums, thus effectively ending the policy.Butearlyterminationfeescanmakethatcostly.

Examine the agent's sales presentation very carefully. The product iscomplex, the terminology is daunting, and agents stand to make highcommissions on permanent policies. Long-term performance, particularly forvariable universal life products, can be adjusted to look very attractive bychoosinghighandunrealisticreturnrates.Sure,youcanendupwithacoupleofmilliondollarswitha10percenteffectiveannualreturn—buthowlikelyisthat,especially when the insurance company is taking some for expenses andpayouts?Makesuretoseethenumberswithrealisticandworst-casescenarios.Be sure you understand everything (and read and ask questions until you do)

beforemakinganinformeddecision.

Question203:Scenario:Iamthirty-eight,marriedwithnochildren,andhave$50,000annualincomeasanemployee.Howmuch,andwhatkindofinsuranceshouldIget?Atthisstageoflife,yourinsuranceneedsarefairlybasic.Thefirstquestion:canyour spouse replace your income? Then, what expenses would you expect tohave? Normal expenses? Mortgage? At this point, it's a pencil-and-paperexercise,andtheruleofthumbofreplacingtenyearsworthofincomeisagoodplacetostart,thoughyoumightneedlessifyourspousehasearningpotential.

Thenextquestionconcernsthefuture.Doyouexpecttohavechildren?Ifso,thatexpandstherequiredamountandalsomakesitmoreimportantthatyoustayinsurablewhiletheyarestilldependent.Buyinsurance—evenifyoudon'tthinkyou need it now. Your employer's group life plan is the best place to startshopping.Youmaygetsomecoverageforfree,butadditionalamountsarecheapand can be had without questions. Youmay choose not to insure your entireneed this way.What happens if you lose your job?A supplemental term lifepolicywithalongleveltermoftwentyyearsmakessense.

Permanentinsurancemaybeagoodideaifyou'vemaxedoutotherretirementsavings vehicles (unlikely at this income level) or if you are trying to buildwealthandhavetroublesavingotherwise.Butformostpeople,alonglevelterminsurancepolicyprobablyischeapestandmakesthemostsense.Buythemostyoucanreasonablyafford,especiallyifyoursurvivorswillhaveadifficulttimereplacingyourincome.

Question204:Disabilityinsurance—doIneedit?Disabilityinsurancereplacesaportionofyourincomeshouldyouremainlivingbutbecomeunabletoearnincome.Doyouneedit?Statisticsshowdisabilityismuchmorelikelythandeath;theaverageworkeristwotothreetimesaslikelytohaveadisabilityclaimthana life insuranceclaimduring theirworking life.Like life insurance, disability produces income for your household when youcan't.

Question205:Myemployeroffersme“anyoccupation”disabilitycoverage.Isthisgood,oristheresomethingbetter?There are two kinds of disability coverage.Own occupation coverage pays ifyoubecomeunabletoperforminyourownprofession.Anyoccupationcoveragepays only if you are unable to perform work for income at all. While anyoccupation insurance sounds better, on further examination you mustdemonstratecompletedisability,thatis,youcannotworkinanycapacitybeforecollecting. This is a stringent test. These policies only pay with severedisabilitiesandsoarelessattractivethanownoccupationalternatives.Doctors,airlinepilots,andotherhighlyskilledprofessionalstendtobuyownoccupationcoverage since theywant coverage if they become unable to perform in theirownspecializedprofession.

Question206:HowmuchdisabilitycoveragedoIneed?Mostdisabilitypoliciespromisetopaysomeportionofyourincomeintheeventof disability—50, 60, or 75 percent. Full income replacement policies areexpensive and are usually not offered through employers. There is somecoveragethroughtheSocialSecuritysystem.Butthecoverageislimited,andthedisabilitymustbesevere.Manystatesofferlimiteddisabilitycoverageaswell,but again disabilities must pass stringent criteria for one to collect. Mostdisability coverage also comes with a waiting period; that is, you can onlycollectafteradefinedperiodoftimeelapses.

Disability needs depend on your income needs, current assets, andalternativesforproducinghouseholdincomeifyoubecomedisabled.Canyourspousereplaceyourincome?Canyoudosomethingelseifyoubecomeinjuredin an auto accident? Remember, income needs often rise during periods ofdisability.What aboutuncoveredmedical expenses and insurancedeductibles?Who is going tomow your lawn, and howmuchwill it cost?Youmay needmorethanyouthink.

Question207:Whatarethemaintypesofhealthcoverageavailabletoday?Whatis“managedcare”?Healthcoveragecomes in twomajor types, eachofwhichmaybecoveredby

some form of health insurance.Managed care consists of a set of servicesmanaged by a health care providing corporation. Private care has nointermediary;yousimplychooseyourdoctordirectly.

Managed care organizations hire or contract with medical professionals toprovide certain services at a certain price. Health insurers finance health carethrough a variety of insurance products but do not deliver the care. HealthMaintenance Organizations (HMOs) provide both; they offer medical careservices and an insurance package to pay for them. Since costs are controlleddirectly,especiallywithin-houseHMOslikeKaiserPermanente,HMOsusuallyprovide the lowest cost but offer the least flexibility to choose amongdoctorsandservicealternatives.Preferred Provider Organizations (PPOs) are a looser confederation of

contracted care providers. Patients can choose among a network of careproviders and canuseout-of-networkproviderswith this coverage, if they arewillingtopayahigherdeductible.Typically,thecareproviderisseparatefromthe insurer. PPOs are somewhat more expensive but offer the patient greaterchoice.

Question208:Whatisthedifferencebetween“deductibles,”“coinsurance,”and“copays”?A copay, or copayment, is a charge paid by the insuredwith each incident ofmedicalcoverage.Ifyouhavea$20doctorcopay,youpay$20foreachvisittoadoctor.Copaymentforhospitalandemergencyroomservicesmaydiffer,andsome plans may offer a different copayment for preventative services like aroutinephysical.Generally,thehigherthecopay,thelowerthecostofinsurance.Coinsurance represents the amount youpay as a percentageof the costs of

eacheventaboveandbeyondthecopayment.Typicalpoliciesrequireyoutopayfor20percentofanyservice,while the insurerpays theother80percent.Thehigherthecoinsurance,thelowertheinsurancepremium.

Finally, thedeductible representsaminimumfloorbelowwhich the insuredpays100percentofcosts.Deductiblesmaybeset for individualsorcombinedforafamily.Ifyouhaveapolicywitha$500individualdeductible,a$20copay,and20percent coinsurance, youwouldpay all costs up to $500/year.Beyond$500,youwouldpay20percentofeachmedicalbillplusa$20copayforeachvisit.Copaymentstypicallydoapplytowarddeductibleamounts.

Question209:EverytimeI'mconfrontedwithhealthdecisions,likeduringopenenrollment,Iambewilderedbythetechnology.WhatfeaturesshouldIlookforinmyhealthplan?Eachchoicehas importantcostfactorsandfeatures.Majorcostfactors includedeductibles,copayments,andcoinsurance(seeQuestion208)andtheportionofthepremiumyou'llhave topay if it is anemployer-sponsoredplan.Typically,you'll have choices among these cost factors; higher premiums will buy youlowercopays,deductibles,andcoinsuranceamounts.

Keyplanfeaturesincludeprescriptiondrugcoverage(isthereany,andwhataredeductibles,coinsurance,andcopays?),maternitycoverage,andpreventativecareprovisions.Ifyouchooseahigh-deductibleplan,doyoustillgetcoverageforphysicalexaminations?Doesprescriptiondrugcoverage limit thecoverageforneworproprietarymedications?Ifyou'reinanindividualplan(notemployerprovided), what are the renewability provisions? You need to shop carefullythrough the matrix of benefits and costs and make a careful decision aboutwhat'srightforyou.Mostemployershaveadvisorstohelpnavigatethemaze.

Question210:Whyhashealthinsurancebecomesuchahotissuerecently?Healthcarecostsandhealthinsurancepremiumshaverisenatastaggeringrate,almost49percentinthe2000–2004period;yetfamilyincomeshaverisenonly8percent during that period. The gap is being made up in part by employerspassinglargechunksofthecostofhealthinsurancepremiumstoemployees.Theonlygoodnewsisthattheseincreasedpremiumsaregenerallypaidwithbefore-taxdollars,andmostself-employedcandeduct100percentofhealthinsurancepremiums.With that said, there are almost 50millionuninsuredpeople in theUnitedStates.People are living longer and comingdownwithmore complex,longer-lasting diseases. Further, with the demise of traditional retirementpensions, people must protect their assets from the financial catastrophe of amajorillness.Formostoftheseissuesthereisnoimprovementinsight.

Question211:HowcanIkeephealthinsurancecostsdown?Whetheranindividualpolicyoranemployerplan,healthinsurancecostscanbe

kept down by choosing higher deductibles, copayments, and coinsuranceamounts(seeQuestion208).Thisappliesbothtocareservicesandprescriptiondrugs.All options should be examined. Some families, particularly thosewithindividual insurance coverage, choose less expensive HMO coverage forchildren and PPO coverage for themselves, as children typically need morefrequentbutlessseriouscare.Puttinganindividualpolicyintheyoungestadult'sname is another way to save a few dollars. The advent of health savingsaccounts (HSAs), an expansion ofmedical savings accounts (MSAs) alreadyavailable to self-employed individuals,will help. These plans, currently beingimplementedinthetaxcode,allowindividualstoreducehealthinsurancecostsbyincreasingdeductiblesandcoveringthemthroughapersonallyownedpretaxsavings account. They are particularly attractive to healthier individuals andfamilies.

HSAs are currently being promoted by the federal government and manyfinancialandhealthinsuranceadvisorsasawayforallworkers—notjustself-employedworkers—tomake health-care costsmore affordable. This becomesespeciallytrueasemployerspaylessandlessofthetab.HSAsareattractiveforfunding increased subscriberhealth costs across awide rangeofhealth issues,including eye and dental care. But they have the added attraction of being asupplementalretirementplan,asfundsnotusedforhealthcarecanbeinvestedand used for retirement, much like a deductible IRA. Finally, asMSAs werelimited to self-employed individuals, plan choices were limited andadministrativecostswerehigh.ButasHSAsbecomemainstream,we'relikelytosee more and better choices for managed individual health-care accounts. Insum,HSAsareprobablythebiggest—perhapsonly—goodnewsonthehealth-carecostfrontinalongtime.

Question212:Iamself-employed.Whataremyoptions?Self-employed individuals face unique health care challenges. Typical healthplans, can costmore than $1,000/month for a family. Premiums are now 100percentdeductible,butitisstillasubstantialexpense.

Therearetwopathstoloweringthesecosts.First,ifyoucangetintoagroup-basedcoveragesomehow,thathelps.Groupplansarepricedconsideringloweradministrative costs and do not require individual underwriting—that is,qualification—ofplanparticipants.Someinsurancecompaniesarewritinggroup

coverage for firms with as few as four or five employees, and some self-employed individualsmay findgroupcoverage throughaprofessionalor tradeorganization. Group plans are essential if you have some preexisting healthsituationthatmayhinderqualification.

Theotherpathistogetaspecialmajormedicalpolicycoupledtoamedicalsavings account, or MSA. The major medical coverage may have very highdeductibles, up to $5,000 per family, but theMSA allows you to save up to$3,000beforetaxestopaythisamountandcoverotherhealth-relatedexpenses(even things like eyeglasses). If you don't use the MSA savings, it can bewithdrawn without a penalty after age fifty-nine-and-a-half; so it acts as asupplementalretirementplan.

Question213:WhatisCOBRA,andhowdoesitwork?COBRAstandsforConsolidatedOmnibusBudgetReconciliationActof1986,apiece of umbrella legislation allowing employees to continue group healthcoverage foraperiodof timeafter termination.Theactwasdesigned toallowemployeestochangejobsortrydifferentformsofemploymentwithouthavingto qualify for and pay for individual coverage immediately. Companies withtwenty or more employees must offer COBRA coverage, which allows theinsured to pay for insurance at the previous group rate usually for eighteenmonths after termination. COBRA coverage is not free but makes coverageavailable at reduced rates. COBRA saves money and maintains insurability.Most individual health insurance providers will accept a COBRA transfereewithoutaphysicalexamorqualificationiftheyhadpreviouscoverageforlongenough.

Question214:Doesitmakesensetogetdentalinsurance?Dental insurance typically has high deductibles and is relatively expensive.Moreover, even themost expensive dental procedures cost just a fewhundreddollars.There isnocatastrophicevent to insureagainstas there iswithhealth,life,ordisability. Ifanemployeroffersdental insurance, that'sgood.Butmostfamilies are better served to put the premiums into savings (especially pretaxmedical savings plans through work or medical savings accounts if selfemployed).

Question215:Whatislong-term-careinsurance?DoIneedit?Long-term-careinsuranceisdesignedtoinsureagainst theriskoffraillyinoldage. You might need extended care for so-called activities of daily living—eating,dressing,cleaning—overalongperiodoftime.Nursinghomesandotherforms of extended care are very expensive, running $25,000 to $100,000/yeardependingonthetypeofcareandlocation.Averagelong-termcareperiodsrunone and a half to two years. But people are living longer, and the chance ofneedingsuchcareatsomepointhasgrown.

Most financial advisors recommend long-term-care insurance if you have amid-range asset base at retirement—between $100,000 and $1 million.Why?People with less are poor enough (or will be soon) to qualify for state aidprogramssuchasMedicaid.Peoplewithsufficientassetscanself-insure,thatis,paymostcostsandhaveenoughleftoverforotherretirementneeds.

W

Chapter12

PROTECTINGPROPERTY

hile life and disability insurance primarily protect income,property/casualty insurance protects from financial loss sufferedthrough adverse events involving property and from loss of the

properlyitself.Forexample,autoinsurancecoversdamageyoumightinflictonsomeoneelsewithyourcar.Dependingoncoverage, it alsoprotectsyou fromthe loss of the car itself. Homeowner's insurance protects in the same way,althoughthelossprotectioncomponentismoreimportantbecauseofhighassetvalue. Property/casualty insurance should be purchased for auto, home, andothermajorassets.

Question216:Howdoesproperty/casualtyinsurancefitintomyoverallfinancialplan?Property/casualty insurance—mainly auto and homeowners' policies—protectagainstfinancialcatastrophecausedbylossofthepropertyorbydamagecausedtootherswithoron theproperty.Thesepoliciescoverhomeandcarcontents,too;sotheyendupcoveringmostofahousehold'sassets.Likehealthinsurance,therearechoicesrangingfromfullcoveragetohigh-deductiblepoliciesdesignedtocoveronlycatastrophiceventswithlargepremiumsavings.Formostpeople,higher-deductible formsmake sense since it is the catastropheyou're guardingagainst,notevery$100bitofdamagethatmightoccur.Aspecialformknownasumbrella coverage goes beyond standard policies to cover very large liabilityexposure—$1 million and upward—combined for all owned property. Withtoday's litigation, umbrella coverage is relatively inexpensive protection,especiallyifyouhavesomethingtoprotectorunusualriskfactors liketeenagedrivers.

Question217:HowmuchautoinsurancedoI/weneed?

It's important to understand the different parts of an auto policy. Most autoinsurancepolicieshaveliability,collision,andcomprehensivecomponentswithanassortmentof“extras”addedon.

Theliabilitycomponentcoversharmordamageyoumightinflictonsomeoneelse inanaccident.Most liabilitycoverageisdividedinto threecomponents:aper-individual, a per-accident, and a property damage dollar amount. Thus, a“100–300–50”policycoversupto$100,000indamagesinflicteduponanotherperson,$300,000indamagesforallpersonsinvolved,and$50,000coveringthevalue of someone else's car or other property involved. Most advisorsrecommendbuyingasmuchliabilitycoverageaspossible.Liabilitycoverageisexpensive,but increasedamountsofcoverageare relativelycheap. Itmaycostonly10percentmoretogofrom$300,000peraccidentto$500,000peraccidentincoverage.Withtheincreasedvalueoftoday'scars,properlydamagecoverageshouldbe$100,000ormoreifpossible.Evenifyouhavelittlewealthtoprotect,some courts “garnish” or attach wages to settle damages, particularly ifnegligencewasinvolvedintheaccident.

Whileliabilitycoverstheinterestsofothersinvolvedintheaccident,collisionand comprehensive coverages protect your own vehicle. Collision insuranceprotectsagainst lossordamageofyourvehicle inanaccident.Comprehensiveinsurance covers loss to your vehicle in nonaccident events—storm damage,theft, fire,andsoforth.Deductiblesusuallyapply to thesecoverages.Youcanchoosedeductibles,anddependingonthevalueofthevehicle,maychoosetogowithoutthesecoveragesaltogether.

Aside from liability, collision, and comprehensive coverages, most autopolicies carry mandatory coverage against damage inflicted upon you byuninsured motorists, and they may have other add-on coverages for medicalpayments foryouandvehiclepassengers,vehicle towing,andcar rental in theeventofdamagetoyourvehicle.Someof theseextrasmaybequiteexpensivewhenconsideringvalueofcoverageactuallyreceived.

Question218:Idrivea1994FordExplorer.ShouldIbuycollisionandcomprehensiveinsurance?Collision and comprehensive insurance protect the value of your vehicle andprovide secondary protection when you drive someone else's vehicle withpermission(theirinsurancecomesfirst).Yourvehiclehasprobablydepreciated

sothatevenatotallosswouldbringasettlementof$3,000orless;soyoumaydecidethesecoveragesaren'tnecessary.Premiumsmayrun10to20percentofthatamount—alargecashoutlayformodestprotection.Checkwithyouragenttogetpremiumcostsandestimatedsettlementvalue.

Youmay choose these coverages if you rent vehicles frequently. Typicallyyourcoveragesapply torentedvehicles,sowithoutcollisioncoverageonyourown car, you probably don't have it when you rent. Supplemental coverageavailable from car rental companies is expensive; it may be cheaper to carrycollision and comprehensive insurance yourself. Notably, you're protected forthe fullvalueof the rental car lessyourdeductible—even ifyour car isworthonly$3,000.

Question219:HowcanIlowermyautoinsurancecosts?Acommonquestion asked each time the renewal notice arrives.You consideryourselfasafedriverwithagoodrecord—andyetthatbillkeepsgoingupandup.Insurancecompaniesremindusthatliabilityexposureandthecosttorepairorreplacecarscontinuetorisesteadily.Today'scarshaveexpensivegadgetsandaresetupformanufacturing—notrepair—efficiencySowhatcanyoudo?

Mostadvisorsrecommendagainsttakingshortcutsonliabilitycoverage.Theplaces to lookarecollision,comprehensive,andso-calledextracoverages, likemedical, towing, and rental car coverage if your car is wrecked. By raisingcollision deductibles, you can save without adding much risk to your overallfinances. Ask yourself howmuch you're willing to pay for that first $500 ofinsurance.Itprobablyisn'tworth$100/year,isit?Theextracoveragescanalsobequiteexpensive;towinginsurancethatmightpay$300atmostmaycost$20to$30/year.

Also, you may be eligible for discounts not even considered—for a gooddrivingrecord,carryinghomeowner'sinsurancethroughthesamecompany,andevenmembership in a professional organization. The bottom line: checkwithyour agent, review each line item, and don't forget to ask how driving a lessexpensivevehiclemighthelp.Makesurethatyoudon'tcauseanaccidentorgettrafficcitations;costwillincreasewithlittletobedoneaboutit.

Question220:EverytimeIrentacar,theagencypitcheshardto

sellCollisionDamageWaivers,LossDamageWaivers,andsoforth.Arethesenecessary?Typically, thecoveragesyoubuy foryourownvehicleapplywhenyou rentacar. So you are covered for liability, collision damage, and the nonaccidentevents covered by comprehensive insurance. Although most auto policies arestandardized,itisworthcheckingwithyourinsuranceagenttomakesure.

Theone “gotcha” is the loss damagewaiver (LDW). If youwreck a rentalcar,carrentalcompaniescanbillyoufor“lossofuse”—thatis,possiblerentalrevenues foregone because the car was out of service. Depending on thecompany,theymaybillyoufor$50/day—moreforanexpensivecar—fortwoorthree weeks or more (and usually longer than really required to repair thevehicle).Yourpolicytypicallydoesn'tcoverthis;sothetenorfifteendollarsyoumightspendforadayofLDWcoveragemightbeworthit,especiallyifyourentafancycar.

Question221:Mybrotherhasanicesportscarandwon'tletmedriveit.HehasfullcoveragebutinsiststhatIcan'tdriveitbecauseIdon'tcarrycollisionorcomprehensiveprotectiononmyownjunker.Isheright?Shortanswer:no.Standardautoinsurancepoliciescoverthecar,notthedriver.Soifyoudrivethecarwithhispermission,youarecovered.

Question222:Howmuchhomeowner'sinsurancedoIneed,andwhatarethemaincostfactors?Theriseinhomevaluesandrecentfire,hurricane,andotherdisastereventshavebrought homeowner's insurance into the spotlight. Simultaneously rising costandriskhavebeenadoublewhammytohomeowners'rates.

Unlike auto policies, largely driven by liability cost, homeowner's policycosts aremainly driven by cost to repair or replace the home.Generally, youshouldinsureforasmuchasyoucansinceamajoruninsuredlosscanreallyhurtyourfinancialposition.Sincelandcan'treallybedestroyed,landvalueshouldn'tbeincludedincoverage.Iftheinsurancecompanyisreluctanttocoverfullvalue(andmostarethesedays),standardcontentsandoutbuildingscoveragecanhelp

make up the difference. Make sure to get some form of replacement valuecoverage (insurance companies are also reluctant to write “full” replacementcoverage these days) to help fight the effects of inflation and, importantly,updatedbuildingcodes.

Skyrocketingcostshavemovedcompaniestoofferveryhighdeductibles—upto $5,000 per event. Such high deductibles can save 30 or 40 percent on thepremium.Rememberthathomeowner'sinsuranceistoprotectwhat'slikelyyourbiggestasset,nottocoversmalllosses.

Question223:HowcanIsaveonmyhomeowner'sinsurance?With annual premiums rising to $1,000 andmore formany homeowners, thisinsurance has become a real budget-buster formany individuals and families.The problem is exacerbated by increasing reluctance of major companies towrite policies, especially in risky fire-or storm-prone areas.Rates varywidelyacrossthecountry;soyourlocationisimportant.

Assumingyou'vedecidedtostaywhereyouare,thedeductibleisthebiggestleveryoucanpull.By raising thedeductible to$500,$1,000,$2,000,or even$5,000,youacceptthesmalllosseswhilecoveringthebigonesandcansaveupto 30 or 40 percent on premiums. Put differently, $300 to $400/year in extrapremiums is a lot to cover $5,000 in potential loss. You should also look atbuyingyourautopolicyfromthesameinsurer.Insurancecompaniesmakemoremoney on auto than homeowner's and may offer attractive discounts for thepackagedeal.

Question224:Irecentlybrokeanexpensivepicturewindow,causing$1,000indamage.Ihavea$500deductiblehomeowner'sinsurancepolicy.ShouldIfiletheclaim?Generally, “no.” You stand to save $500 today, but today most insurancecompanies, unless forbidden by state regulations, are chargingmore to higherriskhomeowners.Untilrecently,claimshistoryhadnoimpactonpremiumsforinsurancealreadyinforce.Butrecently,todealwithescalatingcosts,insurancecompanieshavechangedhomeowner'spolicies toactmore likeautocoverage,where claims can enter into each year's rating. (Many policies still exemptnaturaleventssuchaswinddamagefromsuchincreases,andyoumayalsohave

specialglasscoverage—checkwithyouragent.)Theeventonyourrecordwillmakeithardertochangecompanies,atleastforthenextthreeyears.Gooveritcarefullywithyouragentbeforefiling.

Question225:DoIneedrenter'sinsurance?Particularlyifyou'rerentinganapartmentorcondominium,renter'sinsuranceischeap and affordable protection. Not only does it cover loss of your owncontentsbytheft,fire,flood,etc.,butitalsoprotectsagainstdamageyoumightcause to others. If you accidentally start a fire in your apartment, youmaybeliable for damages—even smoke damage—to other units and to the complexitself. For this protection, the price is attractive, even if you have nothing butparticleboardshelvesandatwenty-year-oldTVyourself.

Question226:ShouldIbuyallofmyinsurancefromonecompanyorthroughoneinsuranceagent?Bylawinmoststates,insurancecompaniesspecializeineitherproperty/casualtyor life/disability insurance products. Because of its specialized nature, healthinsuranceisusuallywrittenbyspecialistcompanies.Soyoucan'tusuallybuyallinsurancefromonecompany.Agents,however,areanothermatter.Agentscaneither be exclusive or “captive,” that is, tied to a specific umbrella brand ofinsurance like State Farm, Allstate, or Farmers, or they can sell and servicemultiplelinesofinsurance.Soyoucanusuallybuylife,disability,andproperly(butnothealth)insurancethroughasingleagent.

Shouldyoubuy fromoneagent?Therearecompellingarguments todo so.First, you develop a relationship; they can understand your entire financialpicture and recommend accordingly. Some offer discounts for buying auto,homeowner's, and life insurance from the same agent and bodyof companies.Realize, however, that some companies use one insurance line (like life) tosubsidizeanother,soyoumightbebetteroffbuyingsimpletermlifefromalifespecialistor fromtheInternet. It'sa tradeoffbetweencostandservice,and thecomplexityofinsurancemaymakeservicemoreimportant.

O

Chapter13

CONCERNINGINCOMETAXES

f those two“sure things”—deathand taxes—peopleprobablygetmoreworked up about taxes. For some people, taxes are the clearestmanifestation of mysterious and overbearing governments; for others,

theyarejustanecessaryandterriblytime-consumingevil.ArecentstudyfoundthatAmericanscollectivelyspendover600billionhourseachyearpreparingtaxreturns.Beyondtimeandeffort, thesubjectof taxesconjuresa lotofemotion,andmisconceptionsandpoordecision-makingarewidespread.

Many ask if they should do their own taxes. It's hard work and tediousarithmetic for some. But besides saving preparer fees, there is an importantbenefit:Preparingtaxescanmakeyoumoreawareofyourfinancialposition.Ifpreparation is left to others, it's still important to understand the process andresult. There are legitimate ways to save on taxes, while others only createillusions, likeincurringadollarofunnecessaryinterestexpensejust tosave30centsbydeductingit.Peopleshouldn'tjumpatattractive-soundingtaxstrategiesbut shouldn't be so afraid as to avoid them, either. The entire topic can't becoveredhere,but the followingquestionsaddresscommonmisperceptionsandwillhelpbalanceyourviewoftaxes.

Question227:IamafraidoftheIRSandreluctanttopreparemyowntaxes.AmIgettingworkedupovernothing?There are many others like you.With that said, a few words about taxpayerresponsibilityareinorder.

Eggedonbyrumoranddarkjournalism,theIRShasbeenpastedwitha“big

brother”image,readytopounceandpunishtheslightestmistakewiththetactofaschoolyardbully.Theremaybeafewincidentsthatfitthisportrayal,butthevastmajorityoftaxpayersareleftalone.Inreality,taxpayersareresponsiblefordeterminingtheirowntaxableincome,andtheyaregivensomelatitudetofairlydetermine and pay taxes on it. The IRS supports and even promotes taxavoidance, that is, the reduction of taxes through legal means.What the IRSdoes not tolerate is tax evasion, that is, where taxes are knowingly andunlawfullyunderpaid.The IRSwill applycertain tests to see ifdeductionsarereasonable and that income is recorded correctly.Through the letter and auditprocess,theywillsingleoutsomereturnsandaskafewquestions.Ifyoumadeanhonestmistakeorhavereasontodowhatyoudid,theIRStypicallyresolvesquickly,efficiently,andinafriendlyway,usuallybyphoneandwithoutpenaltyorlastingrecourse.Thismaynotconvinceyoutodoyourowntaxes,butthefearofendingupinjailformakingamistakeiscompletelyoverblown.

Question228:WhatrecordsdoIneedtokeepformytaxes?Forhowlong?Generally,theIRShastherighttodetailedreviewofyourpastthreeyears'taxes,soyouneedtokeepallrecordsofincomeandexpensesatleastthislong.Ifyouhave a history of tax problems, IRS limits expand, and you should keep allrecords. For long-term transactions such as buying a house or securitiesinvestments, records shouldbekept indefinitely.At somepoint,you'll have todetermine basis in the asset, that is, purchase price plus all additionalexpendituresforhomeimprovementsandothervalue-additems.

Question229:Whatarethebasicstepstodoingmyowntaxes?Doingyourowntaxesnotonlysavespreparationfees,butalsomakesyoumoreawareofyourownfinances—abigsteptowardfinancialsuccess.

The first thing you need to do—important whether you prepare your owntaxes or not—is organize income and expenses. If all income is from anemployer, tracking income is relatively easy. You'll need an expense file forpotentiallydeductibleexpenses likemedical, interest costs,other taxes,andanassortmentofotherexpenses.You'llalsoneed to track investmentactivityandbusinessandrentalproperlyinterests.

Doing your own taxes involves, first, calculating your income andmakingsomeadjustmentstoarriveatadjustedgrossincome(AGI).Wagesandsalaries,investment income and others are added, and IRA and some other “forAGI”expensesarenettedout.Second,determinetaxableincomebydeductingeitherastandard deduction or itemized expenses and an exemption amount fordependents.Thethirdstepcalculates taxonthe taxable income,andthefourthstepcomparesthetaxableamounttowhatyou'vealreadypaidintodetermineanetrefundorpaymentamount.

Admittedly, this sounds simpler than it works out in practice, especially ifyouhavebusinessinterestsorrentalproperties.Butthebasicprocessisthesameandisn'tthatscaryformostpeople,especiallyiforganized.

Question230:MycoworkersurgedmenottogoforapromotionandraisebecauseImightendupinahighertaxbracket.Isthisthinkingright?Inaword,“no.”It is truethatyoumightenduppayingrelativelymoretaxonthenew incomeascompared toyourprevious income,butyouwill still comeout ahead. Even if you move from the 25 percent to the 28 percent federalbracket, you still keep 72 percent of your additional income. Itmight be lessdepending on state income taxes, but by nomeanswill you end upwith lessmoneyoranywhereclose.Perhapsyourcoworkersarejustjealous.

Question231:FriendsandfamilysayIshouldgetabiggermortgageonmyhometoincreasemyincometaxdeductions.Isthisthinkingright?TheanswertothisquestionissimilartothatofQuestion230,onlythistimetheissueisadditionaldeductibleexpensesratherthanadditionalincome.True,mostmortgageinterestexpenseisdeductibleagainstincomefortaxpurposes.Butthemost thisdeductioncansaveisyourmarginal taxrate, that is, thetoptaxratecorrespondingtoyourlevelofreportedincome.Thetoptaxratefortopincomeearners,thatis,singleormarriedpersonsearningmorethan$311,950(2003),is35 percent, and themost you can save by spending a dollar on interest is 35cents.Mostpeople—those in lower taxbrackets—save15,25,or28centsand

maybealittlemoreifstateincometaxesareincluded.Sure,ifyouhavetogetamortgagetobuyahouse,theinterestdeductionisnicebutdon'tgooutandpaydollarsininterestjusttogetcentsoftaxsavings.Itjustdoesn'tmake“cents.”

Question232:What'sthedifferencebetweenataxdeductionandataxcredit?Ataxdeduction isanamountyoucandeductfromyourtaxableincomebeforeapplying a tax rate,while a tax credit is a direct reductionof the amount youowe.Translation:ataxdeductionwillsaveyouanamountdeterminedbyyourtoptaxrate;ifyou'reinthe25percentbracketanddeduct$1,000inqualifyinginterest expense, you'll save $250.On the other hand, a $1,000 tax credit is adirect reduction in your taxes, and you'll save $1,000. Common deductionsinclude mortgage interest expense, properly, state and local income taxes,charitable contributions, and medical expenses exceeding a certain amount.Commoncredits include theall-importantchildcreditavailable tomostpeopleunder an income threshold (in addition to the dependent exemption). Othercreditsareavailableforchildcare,adoption,andcertaineducationalexpenses,tocertainelderlyordisabledpeople,andtosomelow-incomepeoplewithchildren.Anonrefundablecreditcanonlyreducetaxliabilitytozero;arefundablecreditallowstaxliabilitytogobelowzero,meaningtheIRSwritesachecktoyou.

Question233:Iamanemployedsocialworkerandusemyin-homeofficetodopaperworkandarrangeclientappointments.CanIwriteoffanyportionofmyin-homeoffice?Howmuch?WhiletheIRShasgenerallyrelaxedtherulesallowingindividualstowriteoffaportionof theirhomeforbusinessexpenses, thequalifying testsarestill strict,especiallyforemployeeswithabusinessofficeprovided.First,theportionofthehome usedmust be exclusive and used regularly for your business; you can'twrite off part of your living room just because you do paperwork on yourfavorite couch. Next, is a tougher test for employed individuals: is the home“anyone”of thefollowing:(1)yourprincipalplaceofbusiness,or(2)aplacewhere you meet or work with patients or clients in the normal course ofbusiness,or(3)separatefromyourhomeandusedinyourprimarytrade?Giventheprecedingfacts,youprobablydon'tpassthistest.Thehomeofficeisn'tyour

exclusive place of business, and you don't meet clients at home on a regularbasis.Still,it'sworthwatchinghowIRSrulesandyourworkhabitsevolve.

IRS publications give straightforward advice on such complex issues, andIRSPublication587coveringthistopicisnoexception.

Question234:Iwanttostartmakingbirdfeedersinmygarageandwanttowriteoffabout$800intoolsandpartofmygarage.CanIdothis?The IRS makes a careful distinction between activities engaged in to earn aprofit as compared to activities defined as a hobby. If the IRS decides yourbusiness is a hobby, expense deductions are limited to the amount earned andreported fromthehobby. If theactivity is“conductedwith the intent toearnaprofit,” expenses may be fully deductible. The IRS has nine specific tests todeterminewhetherabusinesshas“intenttoearnaprofit”orisonlyahobby.Themainone:doestheactivityproduceaprofitinthreeoffiveyears,orisitlikelyto? That test is combined with other more personal factors. Is the businessconducted in abusinesslikemanner?Does it takea lotof timeandeffort?Doyouhavesubstantialotherincome?Doespersonalpleasureorrecreationplayabigpart?

Soifmakingandmarketingbirdfeedersbecomesabigpartofyourlifeandthere's a good chance of earning the $800 plus directmaterial costs, youmayhavealegitimatebusinessandScheduleCbusinessexpense.ButbewarethattheactivitymightbeacoalminecanarythatservestotriggeranIRSaudit.

Question235:Whataresomeofthecommon—andcommonlyoverlooked—waystoreduceincometaxes?Herearesomecommonpractices:

1. Maximize retirement savings plans. The federal government effectivelysubsidizes retirement savings, directly through deductible IRAs and pretax401(k)contributionsorindirectlybyallowinginvestmentgainstoappreciatewithoutcurrenttaxation.

2.Usepretaxdollarswhereverpossible.Manyemployed individualscanuse

flexible spending plans to pay medical costs (like dentist office visits,eyeglasses),dependentcare,andsomeinsurancepremiums.Pretaxdollarsgo25to35percentfarther.

3.Know what expenses to itemize. Track all household expenses and knowwhen you reach standard deduction limits. Many people fail to itemizelegitimateexpenses.

4.Takeadvantageofnewtaxlaw.Learnhowtousechildcreditsandlowertaxratesforinvestmentincometoyouradvantage.

5.Start a legitimate business. There are tough tests for a legitimate business(see Question 234), but if you can build a good business, many relatedexpensesforhome,travel,etc.becomeeligiblefordeduction.

Question236:DidtheBushAdministrationtaxlawsof2001–2003reallysavememoney?Howandhowmuch?Although the debate continues about effects on the economy and long-termpublic finances, the new tax breaks really do save money for the averageAmerican.Savingscomeinfivemajorways:

Reduced tax rate and elimination of the “marriage penalty.” Top taxrates for average earners dropped 2 to 3 percent. A “married filingjointly” earner making $60,000 after deductions paid $8,626 in 2003federalincometaxes,downfrom$11,107in2000. Higher standard deduction. For the majority of taxpayers who don'titemize,thestandarddeductionforthesamefamilyrosefrom$7,350in2000to$9,500in2003,savingabout$537intaxesata25percentrate.Lowerratesoninvestmentincome.Maximumcapitalgainsanddividendtaxratesdroppedto15percent. Increased credits. The increase of the child credit to $1,000 per childprovidedlargeanddirectsavingsformostfamilies. Retirement plan contributions increased to $3,000 for most IRAs,$14,000for401(k)plans,andcatch-upcontributionsfor fifty-and-overtaxpayers.

Arguably,dollarsavingsavailabletohigher-incometaxpayersarelarger,butmosttaxpayersinmiddleandlowerincomerangescansavehundredsandeventhousandsofdollarsunderthenewlaws.

Question237:Whatis“AMT”?WhendoIneedtoworryaboutit?AMTistheAlternativeMinimumTax,whichcameintobeingmanyyearsagotoboost the taxation of very wealthy individuals using special tax shelters and“preference items” to legally avoid taxes.While the intentionswere good, therules haven't kept upwith the times.Many ordinary earners now earn enoughandspendenoughonpreferenceitemstoqualifyfortheadditionaltax.Familiesearningmorethan$150,000/yearanddeductingmorethan$49,000forpersonalexemptions,standarddeductions,stateandlocaltaxpayments,andstudentloaninterestcanfeelthebite.Familieslivingincoastalareasorbigcities—withhighincomes, housing costs, and local taxes—are particularly vulnerable.Fortunately, recent changes have raised the $49,000 threshold for 2005, butAMTisstillcatchingfarmoretaxpayersthanitsdesignersintendedandaddingalotoftaxplanningcomplexityaswell.

Question238:WhataresomeofthebiggestincometaxtrapsandhowcanIavoidthem?Thephrase“taxtraps”soundsmoresinisterthanitreallyis.Itsoundsasif theIRSwantstaxpayerstooverlookitemsandgetcaught,butthat'snottheintent.Theintent—ofCongress,nottheIRS—istomakecertainbenefitsandprivilegesunavailabletotaxpayersoutsideintendedbeneficiaries.

For example, Roth IRAs are great, but Congress didn't intend to give thislong-term break to joint filers earningmore than $160,000/year, so they set aceiling above which those taxpayers are ineligible. Similarly, Congress didn'tintendforeveryonetodeducteverymedicalexpensebuttoonlydeducttheminreal hardship cases and so set a floor of 7.5 percent of adjusted gross incomebelowwhichsuchexpensesaren'tdeductible.Asimilarfloorof2percentexistsfor“miscellaneousitemizeddeductions,”meaningthatCongressdoesn'twanttohear about them unless they are significant.Phaseouts are the most commonadjustments. With phaseouts, certain benefits such as the child tax credit or

deductible IRAs are fully available belowcertain income levels.But the childtax credit starts to phase out above $110,000 in adjustable gross income untildisappearing completely at $130,000. Finally, there are cutbacks, where theamount deducted for an expense is reduced above a certain income threshold.Itemized deductions are reduced 3 percent for taxpayers earning more than$139,500in2003.

Good tax planning, especially for higher earners, requires being aware oftheselittletaxtrapsandtheintentionsbehindthem.

Question239:I'vebeenthinkingaboutmovingtoadifferentstate,andIamconsideringtaxesasafactor.Doesitreallymakeadifference?The short answer: “yes.” Even federal income taxes, which by definition arenationalinscope,canbedifferent.Why?Becausethebasis—theamountyou'retaxedon—willbedifferent.Ifyoumovefromaplacewithlowwagesandcoststoonewithhighwagesandcosts,theeffectivetaxratewillincrease,andyou'lllikelypayagreaterpercentageofincomeintax.

Buttherealdifferenceisfoundinstateandlocaltaxes,whichcanvaryfromatotalof3.2percentinWyomingtoalmost20percentinseveralEastCoaststates(2003).Somestateshaveamoreprogressive taxcode, soyoumight see taxesreallyjumpifyou'reahighearnerandchangelittleifyouhavemodestincome.California is an example. The reference bookCities Ranked& Rated (Wiley,2004)bythisauthorexaminesthesedifferencesindepth.

Question240:Iownasmallhairstylingsalon.HowshouldIlegallysetupthebusinesstopaythelowesttaxes?Thisisadifficultquestionrequiringcarefulanalysisofyoursituation.Thesizeofthebusinessandwhetheryouhaveemployeesmakesabigdifference.

The choices are sole proprietorship, partnership, and “S” or “C”corporation.Yourchoice isgovernedby threemajorconsiderations: (1)desireforlegalprotection,(2)preferredmethodofreceivingincomeandpayingtaxes,and(3)howyouwanttousethebusinesstobuybenefitsandbuildaretirementplan.Corporateforms(“S”and“C”)providelegalprotectionagainstliabilityfor

eventsthatoccurinthebusiness.“S”corporationsprotectforliabilitybutallowyoutopassincomethroughwithoutpayingtaxatthecorporatelevel.Youpayatlower individual levels. “C” corporations allow you to keep income in thecorporation and pay for benefits out of the corporation, resulting in relativelylimitedwages and dividends passed to you.However, “C” corporation profitsare taxed, and funds you do pass on may be subject to double taxation.Corporationscostmoneytosetupandhaveanumberoflegalrequirements.

Themath iscomplicated,and if employeesare involved,employeebenefitsand retirementbecomeabig consideration.You should look for an advisororCPAamongyourclientele.

Y

Chapter14

YOURFINANCIALLEGACY

oumayhavethoughtestateplanningwasjustfortheveryoldandveryrich. Most people confuse estate planning with estate tax planning.Indeed, estate taxes become important at death for high-net-worth

individuals with over $1.5million (2005). But estate planning covers amuchwider set of issues. It is really about the ownership and transfer of propertythrough life, through incapacitation,andatdeath. It isaboutmakingsureyourassetsarehandledproperlywhenyoucan'tandaboutmakingsureallmembersofyourfamily(orfamilies,ifremarried)areprotected.Insomesense,itisaboutcontrolsinceanestatewithoutatransferplanismanagedbythestateandcourts—alengthy,expensiveprocessoftenwithundesirableoutcomes.Withoutdoubt,estate planning covers those scary what-ifs we don't like to think about andinvolvesscary-soundingthingslikewillsandtrusts,butreally,itisaboutpeaceofmindforyouandyourfamily.

Question241:Weareinourthirtiesandhealthy.Doweneedestateplanning?Olderpeopleandpeoplewithinfirmhealthhavethemostobviousneedstoplantheir own future and the transfer of their property. But younger, healthyindividualsshouldn'tignoreproperplanningforthefutureoflovedonesaroundthem. Families with children need to plan in case something happens to theparents,anditisn'tjustaboutproperly.Whowillgetcustodyofthechildren,andhowwillthosechildrenbesupported?Ifoneparentdies,howeasilyandquicklywill assets transfer to the surviving spouse to continue to meet financialobligations?Iftherearechildrenfromapreviousmarriage,howwillyoumake

suretheyeventuallyreceiveyourassets?Howwillyoupreventyourex-spouse,youex-spouse'snewspouse,or thatnewspouse'schildrenfromreceivingyourassets? You might get a headache just trying to follow this but imagine theheadachesofyourbereaveddealingwiththeseissuesinprobateafteryourdeath.

Question242:Mybrokerandbankbothrecommendedsettingupouraccountsas“JTWROS”—JointTenancywithRightofSurvivorship.Isthisagoodidea?JTWROSguaranteesimmediatetransferandaccesstojointlyownedproperlyatdeath.Otherwise,evenif thespousewere theobviousbeneficiary throughwillor law, assets would likely be frozen until transferred in probate. This is alengthyprocesseven in the simplest cases. JTWROScostsnothingandmakesassets immediately accessible, important for those left behind to keep thingsgoing.

Question243:Iammarriedwithathree-year-olddaughter.DoIreallyneedawill?Hopefully,youwouldneverneedit.Butwhatifyouandyourspousemeetyourend in an accident?Whowill be the custodian for your daughter?Wherewillyour daughter grow up?What if you don'tmeet your end in the accident butbecomeincapacitatedandunabletoconductyourfinances?Whowilltakeover?Mostpeopleunderstandthatawillgivesinstructionsforhowtotransferassetsupondeath.Butitalsogivesinstructionsastowhoshouldtakeovermanagingwhatremainswhenyoucan't.Withoutawill,thestatedecidesaccordingtolaw,notaccording toanyone'swishes.Beyondawill,a trustmight insure financialsustenanceforyourdaughterincaseyourchosencustodianisagoodparentbutabadfinancier.Fortunately,thechancesofsomethinghappeningtobothparentsatonceareslim,butyouneverknow.

Question244:Whatisalivingtrust?Howisitbetterthanawill?Alivingtrustisalegalentitydesignedtoownandmanageabodyofassetsonyourbehalf.Youarethetrustmaker;eachtrusthasatrustee,orcustodian,andat

leastonebeneficiary.Thetrusteecanbeyou,aprofessional,oryourfinanciallysavvyuncle—youdecide.Infact,youcandoanythingyouwantwithatrust—decidingwhat'sinit,whomanagesit,andwhogetswhatfromitandwhen.

The trust owns the assets and continues to do so after death unless youinstructotherwise.Thetrustdistributesassetsandincomeproducedfromthoseassets according to your instructions. The trust effects transfer of your assetswithoutprobateandwithoutawill.Thereare threemainadvantagesofa trustoverawill.First,assetsaretransferredwithoutprobate,savingtime,effort,andprobate cost. Second, the trust can be used to accomplish more complexfinancial wishes, like providing income for your children from a previousmarriage for twenty years after your death. Third, trusts are a good way tochooseprofessionalmanagementforyourassetsbeforeandafterdeath.

Thedownsideof trusts iscost: itmaycost$1,000ormoretosetupa trust,and professional custody costs still more. In the absence of special financialneeds, you may not need a trust. A will and some easily transferred assetsthroughJTWROSownership(seeQuestion242)willprobablydo.Avoidhigh-pressuretrustsalespitches.

Question245:What'sthedifferencebetweena“living”trustandotherkindsoftrusts?Dolivingtrustsavoidestatetaxes?Alivingtrustisarevocabletrust,meaningyoucanchangeitanytimewhilestillliving. The assets in the trust still belong to you and are part of your estatebecauseyouhaven'tcommittedthemtoanybodypermanently.Becausethereisno suchcommitment, living trustsdonot avoid estate taxes—this is apopularmyth.Anirrevocabletrustpermanentlycommitsassetstoothers;itcanbeusedto remove assets from your estate, thus avoiding estate taxes for wealthyindividualsifproperlyplanned.

Question246:Iamdivorcedandremarried.Intheeventofmydeath,Iwanttosupportmycurrentspouseaslongashe/shelives,butthenhaveremainingassetsreverttomychildren.With today's highdivorce rates, this is a commonestateplanning issue, and agood example of how trusts can be set up to achieve yourwishes. There is aspecialkindoftrustknownasaQualifiedTerminableInterestProperty(QTIP)

trustusedtohandlethiskindofsituation.WithaQTIPtrust,youcansetasidesome assets to cover the needs of your current spouse usually bygranting thespousean income interest, that is,making themthebeneficiary for the incomegenerated by the trust.When the spouse dies, that interest terminates, and thetrustremainderrevertstothesecondarybeneficiary,yourchildren.Youmayormaynotenableyourspouse toaccess theassets,orcorpus,of the trustduringtheirlifetime.

Question247:Howbigdoesmyestatehavetobebeforeestatetaxesbecomeanissue?Afterpolicieshadremainedconstant formanyyears, recent tax legislationhasmade a bigmark on estate taxation. Originally, estate taxeswere designed topreventwealthy families frombecomingeverwealthier, redistributingsomeoftheirwealthtoothers.Estatesover$600,000weresubjecttotaxesatveryhighrates, up to 55 percent. For years, only a few people had estate tax planningissues. But in time, more families that one would not consider wealthy weregetting caught in the tax. Families with homes or farms they had owned formany years and even generationswere being forced to sell a principal familyasset just to pay the tax—hardly the original intent. So the bar was raised to$1,000,000 in 2001 with gradual increases through 2009, until it goes awaycompletely—for one year—in 2010.Congresswas reluctant to exempt estatesfrom taxation forever; so in2011, the exemption reverts to$1,000,000,unlesschanged (considered likely) by then. The limits are, in detail, $1,500,000 in2005, $2,000,000 for 2006–2008, $3,500,000 in 2009, no limit for 2010, and$1,000,000 for 2011 and beyond. If you think this makes estate tax planningmoredifficult,you'reright—forthosestillaffected.

Question248:Whatisthedifferencebetweenestatetaxesandgifttaxes?Estatetaxesoccuronassetstransferredatdeath,whilegifttaxesoccuronassetstransferredwhileliving.Formanyyearsuntil2001,thetaxesworkedintandem—the same exclusion, $600,000, applied to both taxes together. That is, giftsmadeduringlifewereaddedtotheestatevalueatdeathtoapplytheexclusionanddetermine tax. Inessence,youcouldn't justgiveawayyourestateonyour

deathbed.The important exception: up to $11,000worth of gifts canbe giveneach year per individual, per recipient, exempt from taxes. So a pair ofgrandparentscangiveupto$44,000/yeartotheirtwograndchildren(twogivers,two recipients). Suchplannedgifts can, over time, transfer a lot ofwealth taxfree forwealthier families.Recent estate tax exclusion changes have not beenfollowed by gift tax exclusions—the exclusion remains at $1,000,000indefinitely (seeQuestion 247 for estate tax exclusions).This hasmade estatetax planningmuchmore complex, but annual $11,000 gifts are still a favoriteestateplanningtool.

Question249:Ibelievethemorelenientestatetaxruleswillexpirein2010andtheexclusionwillrevertto$1million.Ihave$1.5millionandanumberofheirs,includinggrandchildren,andwanttoavoidestatetaxes.WhatshouldIconsider?Here are some of the more common estate tax planning tools used in thissituation:

Marital trusts—if married—allow each partner to use their $1 millionexclusion, giving a $2 million total exclusion. Commonly called “A-B”trusts,the“B”trustissetupuponthedeathofthefirstpartnertoacceptthatpartner'sshareofassetsinlieuofthesurvivingpartner.Typically,the“B”trustcontainsassetsequaltotheexclusionamount.

Annualgifting—Eachyear,$11,000canbegivenperdonor,perrecipient,tax free. Two grandparents giving to three children (or their trusts) canshield $500,000 in taxable assets in about seven-and-a-half years($500,000/$66,000).

529 plan—These college savings trusts allow accelerated gifting; up to$55,000 can be given per donor per recipient in the first year. Giftedamounts can be used for a wide range of educational purposes andtechnically remain under the legal control and ownership of the donor incase there is some unforeseen old-age need (a 10 percent penalty mayapply).

Thereareafewmoreobscureandcomplextools.Forinstance,moneycanbe

donatedtocharityandreplacedindeathbylifeinsurancepurchasedforaspecialirrevocabletrust.Therearealsowaystoputaprimaryresidenceintrusttoavoidtaxation.Thesemore complex strategies should be approached only through acompetentestateattorney.

Question250:Iwantasizableportionofmyassetstogotocharity.Whatarethebestwaystodothis?Theanswerassumesyouwanttocontinuetobenefitfromyourassetswhilestillliving. Otherwise, you could simply donate them today, realizing income taxsavingstodayandpossibleestatetaxsavingslater.

Specialized irrevocable trusts, charitable remainder trusts being the mostcommon, canachieveyourobjective.Charitable remainder trusts allowyou toset an amount aside, receiving an annual payment to support your needs. Theremainder—whatever is left after you die—goes to the charity. A CharitableRemainderAnnuityTrust(CRAT)paysapredefinedannuityeachyearforasetperiod or for life, leaving the remainder for charity. A Charitable RemainderUnitrust (CRUT) pays a fixed percentage ofwhatever is left in the trust eachyear.Projectedremainder interestsaredeductiblefor incometaxpurposes,andassetsandpotentialappreciationcanbeuntaxed.Thebeneficiarycharilymaybemadeknownorkeptsecret.Therecanbemorethanonecharily.

INDEXOFQUESTIONSPARTIManagingMoney

Chapter1:PersonalFinanceBasics

1:Whatispersonalfinance?2:Whyispersonalfinancesoimportant?3:Whatpersonalcharactertraitsarerequiredforfinancialsuccess?4:Regardingourfinances,whatcanandwhatshouldwedoourselves?5:WhereshouldI/wegetstarted?6:Whydopeoplefailfinancially,andhowcanitbeavoided?7:Whatshouldmynetworthbe?8:I'veheardalotaboutthepowerofcompounding.InplainEnglish,whatisit,howdoesitwork,andwhyisitsoimportant?

9:Howdomypersonalfinanceneedschangewithage?10:Howdoesinflationaffectmypersonalfinances?

Chapter2:BudgetingandManagingDailyExpenses

11:Ijustcan'tfigureoutwherethemoneygoes.WhereshouldIlookfirst?12:Whatisbudgeting,andhowshouldI/weapproachit?13:Whatarethemaincomponentsofafamilybudget?14:DoI/weneedtotrackallexpenses?15:Whatarethetwelvestepsofthebudgetingprocess?16:Budgetingtakesdisciplineandcommitmentfromallfamilymembers.

Howdowegetsuchcommitment?17:Mustabudgetbewrittendown?18:Whydobudgetsfail,andhowcanfailurebeavoided?

Chapter3:HowtoSaveMoney

19: Are savings really a single item in the financial plan, or are theredifferenttypesofsavingstoconsider?

20:Whatarethebestwaystosavemoney?21:HowmuchmoneydoI/weneedtosave?22: What's a good rule of thumb for howmuch I/we should save each

month?23:WhereshouldIputmysavings?24:Iwanttobecomeamillionaire.Isthatarealisticgoal?HowdoIpullit

off?

Chapter4:ChoosingandUsingaBank

25:Areallbanksthesame?Whyorwhynot?26:Bigbankorsmallbank,whichisbetter?27:WhatkindsofbankingserviceswillIneed?28:WhichbankshouldIchooseandwhy?29:Howmanycheckingaccountsshouldwehave?30:Whatarethebiggestbankingmistakestoavoid?31:I'veheardalotaboutonlinebanking.Whatisit,andisitrightforme?

Chapter5:AboutDebtandCredit

32: What is the difference between debt and credit, and why is it soimportant?

33:MyrichaunttellsmealldebtisbadbutI'mstillnotsure.Istheresuchathingasgooddebt?

34:Howdopeoplefallintothedebttrap?Howdoesoneavoidit?35:Whatdifferenttypesofcreditareavailable?36:WhatisacreditscoreandhowdoIgetone?Whyisitimportant?37:HowcanIimprovemycreditrating?38: If Iswitch toanothercreditcard,will thatadverselyaffectmycredit

rating?39:Whatisthedifferencebetweendebitandcreditcards?40:Whatdifferentkindsofcreditcardsarethere?41:Rewardcardssoundlikeagoodidea,butwhatarethepitfalls?42:WhatcreditcardsshouldIcarry?43:HowdoIchooseacreditcard?44:WhatismyfinancialresponsibilityifIloseacreditcard?45:Whyisidentitytheftsoimportant,andhowdoIguardagainstit?46:Mywallet/pursewasstolen.Whathappensnow?47:ShouldIpayoffcreditcardseachmonth?48:Whataretherealandhiddencostsofcredit?49:Whatis“APR”?

50:Ingeneral,howshouldIusecreditcards?51:Howdomostpeoplegetintotroublewithcreditcards?52: People tellme thata secondmortgageorhomeequity line isagood

waytocarrydebtorrestructurethedebtIhave.Isthisright,andwhataretheadvantagesanddisadvantages?

53:Igethitseveraltimesaday,oftenbytelemarketers,withproposalstocashouthomeequitythroughrefinancing.Whendoesthismakesense?

54:Ihavea$30,000balanceonmyGoldMasterCard.WhatshouldIdo?

Chapter6:MakingBigPurchases

55:Ingeneral,what'sthebestwaytoplanforbig-ticketpurchases?56:IthinkIneedanewcar.WhatalternativesshouldIthinkabout?57:Ireallydoneedanewcarnow.Leaseitorbuyit?58: I need a new refrigerator, and the appliance store is offering “six

monthssameascash.”ShouldIbeimpressed?59: My family really wants a new $3,000 plasma TV. How should I

evaluatewhetherIcanaffordit?60:Whatarethealternativestobuyingexpensive,newstuff?61: My friends always try to impress me with their purchases—boats,

vacationhomes,whatever.ShouldIbeimpressed?62:ShouldIbuytheextendedwarranty?

PARTIIPlanningforLifetimeGoals

Chapter7:BuyingaHome

63:Everybodysaysbuyingahomebringsanumberoffinancialbenefits.Aretheyright?Why?

64:WhatkindofhouseshouldIbuy?65:HowdoItellifahomeisoverpriced?66:HowmuchhousecanIafford?67:CanIbuyorsellahomewithoutarealtor?68: Obviously themortgage is a big factor.What kind should I get and

why?69:Howbigshouldmymortgagebe?70:ShouldIgeta30-yearmortgageorsomethingshorter?71:Whyareinterestratessoimportant?Dotheyreallymakeadifference?

72: Whatmakesmortgage rateschange,andwhat should Ikeep trackofandwhy?

73:Whataretherealcostsofowningahome?74:Whatareclosingcosts,andhowshouldtheybepaid?75:WhenshouldIconsiderrefinancing?76:ShouldIconsiderpayingoffmymortgageearly?Whyorwhynot?77: Myfriends tellmeIshouldbuyrentalproperty. Is thisgoodadvice?

WhatdoIneedtoconsider?

Chapter8:PlanningforCollege

78:Howmuchdoweneedtosaveforcollege?79:Whatarethemainwaystofinancecollegecosts?80:Whatarethebestsavingsalternatives,andhowdotheywork?81:I'veheardalotabout529plans.Whatarethekeyfeaturesandprosand

cons?82:HowdoIchooseastateforour529savingsplan?83:Whataretheadvantagesandpitfallsofprepaidtuitionplans?84:Whatarethemajorformsoftaxreliefforcollegecosts,andhowcan

theyhelp?85:Whatarethedifferentkindsoffinancialaid,andwhichisbest?86:How“poor”dowehavetobetoqualifyforfinancialaid?87:What'sthedownsideofstudentloans?88:ShouldIborrowagainstmyhomeequitytofinancecollege?89:Givenallthetools,whatisthebeststrategyformeetingcollegeneeds?

Chapter9:PlanningforRetirement

90:EverydayIreadabouttheimportanceofretirementplanning.Whyhasit become such a big issue? 91: What are the major elements of aretirementplan?

92: How do I determine my total needs for retirement? Are there anyfactorsIcancontrol?

93:SupposeIdecide,aftertotalneedsandentitlementanalysis,thatIneed$3,000/month for thirty years of retirement to achieve my desiredstandardofliving.HowdoIconvertthatintoanamounttosave?

94:WithregardtoSocialSecurity,abouthowmuchincomecanyoucounton?

95:Iworkedallmylife,andmyspousestayedathomeandonlyworkedsporadically. Howmuch Social Security will we get?What if I passaway?

96:Iwasbornin1956.Whataremyretirementoptions,andhowdotheyaffectmySocialSecuritypayout?

97: I divorced my husband twenty years ago. To what, if any, SocialSecurityamIentitled?

98:Myincomeisn'tveryhighnow,notenoughtocoverbothcollegeandretirementneeds.WhatshouldIfocuson?

99:Scenario.Iwasbornin1956andplantoretireatagesixty-sixyears,four months, earning about $50,000/year. My spouse will retire twoyears later with earnings of about $25,000. Can we run a roughcalculationofwhatIneedtosave?

100:Whatarethedifferentemployerretirementplansavailable?Canyousummarize?

101:Ihaveapensionplan.Isthereanythingtoworryabout?102:Areretirementsavingsplanstax-free?103: I plan to leave my current position. What are my retirement plan

options,andwhichisbest?104: My company retirement plan has an option to take a lump sum at

retirementorconverttoanannuity.Whichisbetter?105: Howdo401(k)planswork,andwhyiseverybodysopositiveabout

them?106:HowmuchcanIcontributetomy401(k)?107: My employer offers a series of 401(k) investment choices. How

shouldIallocatemyinvestments?ShouldIrotatethemactively?108: I've heard you can'twithdraw funds from a 401(k) plan before age

59½withoutincurringa10percentpenalty.Whataretheexceptions?109:WhatshouldIlookforinagood401(k)plan?110: Iwant tobuyahome,andhaveheardthatIcanborrowagainstmy

401(k)plantodoso.CanI,andisitagoodidea?111:Iamaschoolteacher,andwehavea403(b)plan.Isthisdifferentfrom

a401(k)?How?112:HowmuchcanI/wecontributetoanIRA?113: What's thedifferencebetweenadeductibleandnondeductible IRA?

WhenareIRAsdeductible?114:WhatisaspousalIRA?

115:WhatisaRothIRA,andhowisitbetterthanatraditionalIRA?116:Ourcombinedfamilyincomeexceeds$170,000.Canweandshould

westillcontributetoanIRA?117:WhereshouldIkeepandinvestmyIRAassets?118: What kinds of investments can I use for an IRA, and which

investmentsarebest?119: I ammost comfortable with real estate investments. Do IRAs and

otherretirementplansallowdirectrealestateinvestments?120:Iamself-employed.Whatretirementplansareavailable,andhowdo

Ichoosethebestone?121: Is there a timewhere Imustwithdraw frommy IRAs?When,how

much,andwhattaxes?122:WhendomySocialSecuritybenefitsbecometaxable,andhowmuch

taxwillIpay?123:WhathappensifIprematurelywithdrawfrommyIRAor401(k)?124:Whatareannuities,andhowdotheywork?125:Howmuchannuitycanyougetforyourmoney?126:Whataretheprosandconsofannuities?127: What are reversemortgages, and howcan I use them in retirement

planning?128:Canyousummarizeretirementplanningandsavingstrategy?129:Scenario:IamfiftyandknowI'veputoffsavingforretirement.Ijust

spent a lot on sending my children to school. My income is$85,000/year,butIonlyhave$25,000inretirementsavings.Iliveina$100,000homewitha$60,000mortgage.WhatshouldIdo?

130:Scenario:Iamfortyandreallywanttoretireearly.CanI?How?Myassetsareincome$80,000,home$250,000,mortgage$175,000at7.5percent,currentsavings$40,000,andretirementsavings$60,000.

Chapter10:AboutInvesting

131:Whyisinvestingsoimportantinpersonalfinance?132:Ihavemysavingsinabank.Isthisinvesting?133: Please give a summary of themajor investment types I need to be

familiarwith.134:Whatisthelong-termtrackrecordforthemajortypesofinvestments?135: Are there good rules about how to allocatemy investments among

differenttypes?

136:Howactivelyinvolvedcan/shouldIbeinmanagingmyinvestments?137:Asaninvestor,itisobviousthatIneedtostayinformed.Whatarethe

bestbasicinformationsources?138:Iamabeginninginvestor.ShouldIuseafull-servicebroker?139:HowdoIchooseadiscountbroker?140:Whatisthecaseforinvestinginindividualstocks?141:Whatisthecaseforbondinvesting?142:Whatisthecaseformutualfundinvesting?143:Whatisthecaseforrealestateinvesting?144:Whatisthecaseforcommodityinvesting?145:WhatisNASDAQ,andhowisitdifferentfromtheNYSE?146:HowshouldIdecidewhethertoinvestinmutualfundsorindividual

stocks?147: Mostmediastockmarketreportshighlight theDowJonesIndustrial

Average.Isitstillagoodindicatorofmarketperformance?148:Whatisastockreallyworth?149:Pleasecompareandcontrastgrowthandvalueinvesting.150:Ihearalotaboutdollar-costaveraging.Isthisjustabuzzword,orisit

somethingtoknowmoreabout?151:Whatisaportfolio,andhowdoIbuildone?152:HowdoIselectastock?153: How do I tell if a business (stock) is improving or has declining

prospects?154:HowdoItellifastockisovervalued?155:Whatismeantbymarketcapandwhyisitimportant?156:Ihaveitnow.WhendoIsellit?157:Recentmarketvolatilityscaresme.WhatshouldIdoaboutit?158:HowdoIdefendmyportfoliofromloss?159:Arestocksplitsagoodthing?160: I am lookingat twocompanies, onepays adividend, and theother

doesn't.Whichisthebetterinvestment?161:Whataretheprosandconsofbuyingstocksonmargin?162:Ihearrecenttaxchangeshavefavoredinvestors.How?163:Myunclesayshemakesalotofmoneysellingstocksshort.Canyou

commentonthisstrategy?164:Giveasummaryofthedifferentkindsofbondsandhowtheywould

beusedindifferentportfolios.

165:MyfriendtellsmethatIshouldinvestinbondsbecausetheyareriskfree.Isthisright?

166:HowdoItellifabondis“junk”?167:HowcanIlearnmoreaboutspecificbondinvestments?168:Whicharebetter—taxableortax-exemptbonds?Whenandwhy?169:GivemeacrashcourseonU.S.Treasurybonds.170: I'm concerned about how rising interest rates might affect my

portfolio.WhatshouldIdo?171:Iliketheideaofinvestinginincome-producingsecurities,butI'mnot

surebondsareforme.Whataresomealternatives?172:Whataremutualfunds?173:Canyouelaborateonthecostsofmutualfundinvesting?174:Howshouldmostinvestorsusemutualfunds?175:Ingeneral,howmanymutualfundsshouldIown?176:Whichisbetter—loadorno-loadfunds?177: Fund listings in the newspaper showClassA,B, andC shares for

manymutualfundgroups.Arethesegrades,orwhat?178: Whatare themajor tax implicationsofmutualfundinvesting?How

canIavoidtaxsurprises?179:HowshouldIselectafund?180:Myfundcompanyhasreceivedbadpresslately.HowdoIdecideif

it'stimetopullout?181:Whatisanexchangetradedfund?Whataretheprosandcons?182:WhatkindsofETFsareavailable?183:HowshouldIuseETFsinmyportfolio?184:Describethedifferentwaystoinvestinrealestateandtheirprosand

cons.185: All my friends seem to be making money with their real estate

investments.Theybragabouteasygains.AmImissingsomethingorarethey?

186:Whatareequityoptions,andwhatshouldIknowaboutthem?187:Ithoughtalloptionplayswererisky.Rightorwrong?188:Scenario:Ihave$4,500toinvest.WhatshouldIdo?189: Scenario: I am a thirty-year-old novice investor with $50,000 to

invest,mostly frompersonal savings and a small inheritance.WhereshouldIinvest,andwhatshouldIavoid?

190: Scenario: I have $100,000 invested, mainly in long-term growth

stocks and index funds. I may be headed for a period of incomeinstability.HowdoIrebalancemyportfoliotogeneratemoreincome?

PARTIIIKeepingtheShiponCourse:AvoidingFinancialSurprises

Chapter11:ProtectingLifeandHealth

191:WhyshouldIbuylifeinsurance?192:HowmuchlifeinsurancedoIneed?193:Whataretheadvantagesofgrouplifeinsurance?194:WhatdifferenttypesoflifeinsurancecanIbuy?195:DoIbuytermorpermanentinsurance?196:Whatisthebestwaytobuylifeinsurance?197: My insurance agent talks about add-on “riders” to life insurance

policies.Igeteasilyconfusedbythejargonandbuzzwords.WhatdoIreallyneedtoknow?

198:ShouldIconsiderbuyinglifeinsuranceformychildren?199:Ingeneral,whatarethetaximplicationsoflifeinsurance?200: What factors drive life insurance cost? If I have high risk factors,

whatshouldIdo?201:Isthechoiceoflifeinsurancecompaniesimportant?202:Whataresomeofthedisadvantagesinbuyingwholeoruniversallife?203: Scenario: I am thirty-eight, married with no children, and have

$50,000annualincomeasanemployee.Howmuch,andwhatkindofinsuranceshouldIget?

204:Disabilityinsurance—doIneedit?205:Myemployeroffersme“anyoccupation”disabilitycoverage.Isthis

good,oristheresomethingbetter?206:HowmuchdisabilitycoveragedoIneed?207:Whatarethemaintypesofhealthcoverageavailabletoday?Whatis

“managedcare”?208: What is the difference between “deductibles,” “coinsurance,” and

“copays”?209: Every time I'm confronted with health decisions, like during open

enrollment,Iambewilderedbytheterminology.WhatfeaturesshouldIlookforinmyhealthplan?

210:Whyhashealthinsurancebecomesuchahotissuerecently?211:HowcanIkeephealthinsurancecostsdown?

212:Iamself-employed.Whataremyoptions?213:WhatisCOBRA,andhowdoesitwork?214:Doesitmakesensetogetdentalinsurance?215:Whatislong-term-careinsurance?DoIneedit?

Chapter12:ProtectingProperty

216: How does property/casualty insurance fit into my overall financialplan?

217:HowmuchautoinsurancedoI/weneed?218: I drive a 1994 Ford Explorer. Should I buy collision and

comprehensiveinsurance?219:HowcanIlowermyautoinsurancecosts?220: Every time I rent a car, the agency pitches hard to sell Collision

Damage Waivers, Loss Damage Waivers, and so forth. Are thesenecessary?

221:Mybrotherhasanicesportscarandwon'tletmedriveit.HehasfullcoveragebutinsiststhatIcan'tdriveitbecauseIdon'tcarrycollisionorcomprehensiveprotectiononmyownjunker.Isheright?

222:Howmuchhomeowner'sinsurancedoIneed,andwhatarethemaincostfactors?

223:HowcanIsaveonmyhomeowner'sinsurance?224: I recently broke an expensive picture window, causing $1,000 in

damage. I have a $500 deductible homeowner's insurance policy.ShouldIfiletheclaim?

225:DoIneedrenter'sinsurance?226:ShouldIbuyallofmyinsurancefromonecompanyorthroughone

insuranceagent?

Chapter13:ConcerningIncomeTaxes

227: IamafraidoftheIRSandreluctanttopreparemyowntaxes.AmIgettingworkedupovernothing?

228:WhatrecordsdoIneedtokeepformytaxes?Forhowlong?229:Whatarethebasicstepstopreparingmyowntaxes?230:MycoworkersurgedmenottogoforapromotionandraisebecauseI

mightendupinahighertaxbracket.Isthisthinkingright?231:FriendsandfamilysayIshouldgetabiggermortgageonmyhometo

increasemyincometaxdeductions.Isthisthinkingright?232:What'sthedifferencebetweenataxdeductionandataxcredit?233: I am an employed socialworker and usemy in-home office to do

paperwork and arrange client appointments. Can I write off anyportionofmyin-homeoffice?Howmuch?

234:Iwanttostartmakingbirdfeedersinmygarageandwanttowriteoffabout$800intoolsandpartofmygarage.CanIdothis?

235:Whataresomeofthecommon—andcommonlyoverlooked—waystoreduceincometaxes?

236:DidthenewBushAdministrationtaxlawsof2001–2003reallysavememoney?Howandhowmuch?

237:Whatis“AMT”?WhendoIneedtoworryaboutit?238: Whataresomeofthebiggest incometaxtrapsandhowcanIavoid

them?239: I've been thinking about moving to a different state, and I am

consideringtaxesasafactor.Doesitreallymakeadifference?240: I own a small hairstyling salon. How should I legally set up the

businesstopaythelowesttaxes?

Chapter14:YourFinancialLegacy

241:Weareinourthirtiesandhealthy.Doweneedestateplanning?242: Mybroker and bank both recommended setting up our accounts as

“JTWROS”—-Joint Tenancy with Right of Survivorship. Is this agoodidea?

243:Iammarriedwithathree-year-olddaughter.DoIreallyneedawill?244:Whatisalivingtrust?Howisitbetterthanawill?245: What's the difference between a “living” trust and other kinds of

trusts?Dolivingtrustsavoidestatetaxes?246: I am divorced and remarried. In the event of my death, I want to

support my current spouse as long as he/she lives, but then haveremainingassetsreverttomychildren.

247: How big doesmy estate have to be before estate taxes become anissue?

248:Whatisthedifferencebetweenestatetaxesandgifttaxes?249:Ibelievethemorelenientestatetaxruleswillexpirein2010andthe

exclusionwillrevert to$1million.Ihave$1.5millionandanumberofheirs,includinggrandchildren,andwanttoavoidestatetaxes.What

shouldIconsider?250: Iwanta sizableportionofmyassets togo tocharity.Whatare the

bestwaystodothis?

Copyright©2005PeterSanderAllrightsreserved.Thisbook,orpartsthereof,maynotbereproducedinanyformwithoutpermissionfromthepublisher;exceptionsaremadeforbrief

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