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Basics of Personal Financial Planning [date] [venue] [contact information]

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1 Basics of Personal Financial Planning [date] [venue] [contact information]

2 Personal Financial Planning Section Introduction About the PFP Section & PFS Credential The AICPA PFP Section provides information, resources, advocacy and guidance for CPAs who specialize in providing estate, tax, retirement, risk management and investment planning advice to individuals and their closely held entities The CPA/Personal Financial Specialist (PFS) credential distinguishes CPAs as subject-matter experts who have demonstrated their financial planning knowledge through experience, education and testing 2

3 Personal Financial Planning Section Todays Objectives You gain an enhanced understanding of the basics of financial planning and how a companys compensation and benefits programs add to your financial well-being You gain an enhanced understanding of basic investing concepts and how to develop your investment plan You gain an enhanced understanding of how a Companys compensation and benefits programs can contribute to the success of your investing You identify and commit to taking the actions you can to significantly enhance your financial well-being 3

4 Personal Financial Planning Section Life Events: Will You Be Ready? Premature Death Retirement Serious Illness Death of Spouse Aged Parents Children Getting Married Second Home Remarriage Starting a Business Paying for College Divorce Job Loss Relocation Home Purchase Birth of Children Marriage Temporary Disability 4

5 Personal Financial Planning Section Lifes Financial Trade-Offs CURRENT NECESSITIES FUTURE NECESSITIES CURRENT EXTRASFUTURE EXTRAS Basic shelter, food clothing, transportation and medical care Basic shelter, food clothing, cash for emergencies and nursing home care Largerhome, private college, retirement travel, bequests/charity New kitchen, new car, vacation, family gifts Trade-offs 5

6 Personal Financial Planning Section The Value of a Financial Plan A financial plan will help you to clarify: Your financial goals Strategies to achieve the goals Specific steps to implement the strategies 6

7 Personal Financial Planning Section Areas to Explore Saving Managing debt Insurance Investing Education funding Retirement funding Pre-retirement planning Incapacitation planning Estate planning Company stock ownership 7

8 Personal Financial Planning Section The Financial Planning Process What do you want? What will you have? Will you have a shortfall? What strategy will you employ? What actions will you take? 8

9 Personal Financial Planning Section What Do You Want? These are your financial planning goals Each goal will have its own horizon For the period of accumulation For the period over which it will be spent Make a list and refine as you go along Start with broad ideas and work toward increasingly specific and measurable goals 9

10 Personal Financial Planning Section What Will You Have? What you have now What you will save from future income Future investment earnings on the above if invested Expected future benefits 10

11 Managing Debt

12 Personal Financial Planning Section What Managing Debt Means Conquering excessive debt Using debt wisely: Credit cards 401(k) plan loans Home mortgages Home equity loans Automobile debt Maintaining a good credit history 12

13 Personal Financial Planning Section Debt Ratios Housing expense ratio Housing expenses (mortgage, taxes and insurance) should not exceed 28% of gross pay Gross pay is before taxes and deductions Debt to income ratio Total consumer debt (not including mortgage) should be less than 20% of take-home-pay Take-home pay is after taxes and deductions 13

14 Personal Financial Planning Section Warning Signs of Too Much Debt Unable to save 10% or more of gross income Habitually pay only the minimum monthly payments on your credit cards Borrowed from one lender to pay another Asked a friend or relative to co-sign a loan because credit record is weak Unable to figure out how much you owe Would be in immediate financial trouble if you lost your job tomorrow 14

15 Personal Financial Planning Section Conquering Debt Stop borrowing Start using a debit card Prioritize your debt repayment Seek lower rates Determine the maximum you can pay Repay highest cost debt first Continue paying the maximum 15

16 Personal Financial Planning Section Decrease Debt or Invest? Pay down debt when you cant invest at a higher rate 401(k) Match* Credit Card InvestmentMortgage Interest Paid / Received 100.0%18.0%8.0%6.5% Tax 25%--0.0%-2.0%-1.6% Net Paid / Received100.0%18.0%6.0%4.9% * 100% of first 3% of your pre-tax regular contributions for ABC Company. 16

17 Personal Financial Planning Section Using Home Mortgages Wisely Determining whether buying is appropriate Choosing the right type of mortgage Deciding if you should refinance Knowing whether to pay points Deciding whether to prepay mortgage principal 17

18 Personal Financial Planning Section Is Buying a Home Right for You? BuyingRenting Change location frequentlyNoYes Maintenance responsibilitiesYesNo Ability to customizeYesPerhaps Payment increasesPerhapsLikely Investment elementYesNo Tax benefitsYesNo Initial costsYes 18

19 Personal Financial Planning Section Tax Benefits of Home Ownership 19

20 Personal Financial Planning Section Types of Mortgages 20

21 Personal Financial Planning Section Consider a Fixed Rate Mortgage When: You intend to live in your home for a significant period of time, or You anticipate rising interest rates in the future 21

22 Personal Financial Planning Section Consider an ARM When: Fixed rate is at least 2% points greater than adjustable rate You expect your income will increase enough to cover any potential payment increases You expect to move before the rate increases (beware of prepayment penalties) 22

23 Personal Financial Planning Section Prepaying Mortgage Principal 360 $170, $89,279 Number of PaymentsTotal Interest Paid Standard Payment Additional $150 Per Month Assumes a 30 year fixed-rate mortgage of $100,000 at 8.25% 23

24 Personal Financial Planning Section Consider Prepaying Principal When: You use the standard deduction You invest conservatively 24

25 Personal Financial Planning Section Maintaining a Good Credit History Establish a good credit history Obtain your credit report Understand your credit report Correct mistakes in your credit report 25

26 Saving & Investing

27 Personal Financial Planning Section Importance of Saving and Investing If you dont have the following Sufficient assets fully devoted to your goal(s) Expected future benefits from third parties Expected future borrowing Then you will need the following to reach your goal(s) Future savings devoted to your goals Future earnings from investing the above if you invest those assets 27

28 Personal Financial Planning Section Key Saving and Investing Concepts Saving versus investing Combining saving and investing Saving and investing early Tax-deferred saving and investing Tax-deductible saving and investing Saving and investing using employer contributions 28

29 Personal Financial Planning Section Saving Versus Investing SavingInvesting Means Not spending money Doing something with money to earn a return Needs to be done In a regular, disciplined manner Carefully and with due consideration 29

30 Personal Financial Planning Section Combining Saving and Investing Saves $2,000 per year Starts at age 25 Saves in a non-interest bearing account Saves $2,000 per year Starts at age 25 Invests and earns an 8.9% pretax and 6.68% after-tax return VickieStan 30

31 Personal Financial Planning Section Combining Saving and Investing StanVickie 31

32 Personal Financial Planning Section Saving and Investing Early Saves $2,000 per year Starts at age 35 Continues for 30 years Invests and earns an 8.9% pre-tax and 6.68% after-tax return Saves $2,000 per year Starts at age 25 Stops after 10 years Invests and earns an 8.9% pre-tax and 6.68% after-tax return VickieStan 32

33 Personal Financial Planning Section Saving and Investing Early StanVickie 33

34 Personal Financial Planning Section Tax-Deferred Earnings Saves $2,000 per year Starts at age 25 Continues for 40 years Invests in a taxable account and earns an 8.9% pre-tax and 6.68% after-tax return Saves $2,000 per year Starts at age 25 Continues for 40 years Invests in a Tax-Deferred account and earns an 8.9% pre-tax return VickieStan 34

35 Personal Financial Planning Section Tax-Deferred Earnings StanVickie 35

36 Personal Financial Planning Section The Saving Process What do you want? What will you have? Will you have a shortfall? What strategy will you employ? What actions will you take? 36

37 Personal Financial Planning Section What Do You Want? Identify your specific savings goals Identify your time horizon Quantify your saving goals Prioritize your saving goals 37

38 Personal Financial Planning Section Identify Your Specific Saving Goals Pay down existing debt Create an emergency fund Save for retirement Accumulate a down payment for a house Build a college fund for your childrens education Set aside money for a specific goal (vacation, fun and games, etc.) 38

39 Personal Financial Planning Section Create an Emergency Fund Set aside 2 to 4 months of living expenses Use it for a crisis (i.e., roof leaks) Use it and replace it Dont use it for discretionary spending (i.e., vacation) 39

40 Personal Financial Planning Section Save for Retirement Do everything possible NOW Start earlyyoull end up with more 40

41 Personal Financial Planning Section Identify Your Time Horizon Identify number of months or years until goal Allow as much time as possible: You can accept a lower investment risk Your monthly saving and investing commitment will be less 41

42 Personal Financial Planning Section Examine Your Spending Habits Keep a list of all spending for one month Compare total spending to take-home pay Examine closely if you have a substantial unexplained gap Become highly knowledgeable about your expenses 42

43 Personal Financial Planning Section Identify Ways to Save More Save your next raise Save your next bonus Reinvest dividends and interest Save all cash gifts Rent instead of buying (books, videos, etc.) Delay buying a new car upon paying off present car loan Save the donut money and lose weight! Buy generic products Trim your spending by 5% Be creative 43

44 Personal Financial Planning Section What About Investing? Combined with savings, a key resource for achieving your financial goals Investing skills are needed to prudently utilize Company 401(k) investments IRAs investments Savings invested outside these plans All investments involve risks Approach investing carefully 44

45 Personal Financial Planning Section What Investing Carefully Means Phase I:Learn investing basics Phase II:Develop your investment plan Phase III:Implement your investment plan 45

46 Investing Basics and Planning

47 Personal Financial Planning Section Why Learn Basic Investing Concepts? ALL investments involve risks Even so-called risk-free investments like a cash As such, approach investing carefully Learning basic investing concepts is part of investing carefully 47

48 Personal Financial Planning Section What Are The Major Asset Classes? Major Asset Class CharacteristicsGoals Historical Average Returns* CashMatures in less than one year Capital preservation Liquidity 3-4% BondsFixed income Varied maturities Income Capital preservation 5-7% StocksCompany ownershipPossible dividend income Capital appreciation 10-13% Hard assetsAsset ownershipCapital appreciation Inflation hedge Varies * Pretax return over 75 years through

49 Personal Financial Planning Section What Risks are Involved in Investing? Primary long-term risk Inflation riskLoss of purchasing power Primary short-term risk Volatility riskInstability of investment Other risks Business risk Market risk Liquidity risk Interest rate risk Currency risk Inherent risks of a particular business Likelihood that the market as a whole will fall Risk of not being able to access money when needed Loss of principal on fixed-rate investments due to rising interest rates Investments value will be affected by changes in exchange rates 49

50 Personal Financial Planning Section How are These Risks Managed? Primary long-term risk Inflation riskInvest in stocks Primary short-term risk Volatility riskHold investments for the long- term Other risks Business risk Market risk Liquidity risk Interest rate risk Currency risk Diversify within an asset class Diversify among asset classes Have an emergency fund Ladder portfolios Diversify among countries or hedge 50

51 Personal Financial Planning Section However, Stocks Have More Volatility Risk Lower Deviation Higher Deviation Degree of Volatility Higher Return Lower Return Annual Return 5% 10% 15% 20% Cash Intermediate-Term Government Bonds Large Company Stocks Small Company Stocks 51

52 Personal Financial Planning Section 150% Manage Volatility Risk by Investing Over Time Small Company Stocks Large Company Stocks Long-Term Government Bonds Cash One-Year Holding Periods Five-Year Holding Periods Twenty-Year Holding Periods Average Return 3.7%10.4%12.7% 5.4% -75% -50% -25% 0% 25% 50% 75% 100% 125% Ranges of Return Range of compound annual returns over the period Source: Ibbotson Associates, Volatility Risk Over Time 52

53 Personal Financial Planning Section Managing Business and Market Risks Portfolio Risk Number of Holdings Portfolio Risk= Market Risk + Business Risk Business Risk Market Risk 53

54 Personal Financial Planning Section Current Bonds Real Estate Money market funds Convertible bonds Small-company stocks Certificates of deposit Large-company stocks Utility stocks Zero coupon bonds Return Deferred Lower Liquidity Risk Higher Manage Liquidity Risk by Diversifying 54

55 Personal Financial Planning Section Managing Interest Rate Risk Managed by Laddering Portfolio of Bonds Price Interest Rates Bonds Price Interest Rates 55

56 Personal Financial Planning Section Risk / Return Trade-Offs: Example 1 Degree of Volatility Lower Deviation Higher Deviation Degree of Volatility Higher Return Lower Return Annual Return 5% 10% 15% 20% Cash Intermediate-Term Government Bonds Large Company Stocks Small Company Stocks 56

57 Personal Financial Planning Section Risk / Return Trade-Offs: Example 2 Cash vs. Bonds vs. Stocks CashBondsStocks Current yield Appreciation Total return Estimated income 30% After-tax return Inflation rate After-tax real rate of return Relative risk 3.3% 0.0% 3.3% (1.0)% 2.3% (3.1)% (0.8)% Low 4.8% 0.0% 4.8% (1.4)% 3.4% (3.1)% 0.3% Medium 2.2% 6.5% 8.7% (2.6)% 6.1% (3.1)% 3.0% High 57

58 Personal Financial Planning Section Risk / Return Trade-Offs: Example 3 Sub-Categories Within Major Asset Classes Cash Bonds Stocks Hard Assets International Small Company Stocks Large Company Stocks Long Term Intermediate Term Short Term High Risk/ High Return Potential Low Risk/ Low Return Potential 58

59 Personal Financial Planning Section Risk / Return Trade-Offs: Example 4 Taxable vs. Tax-Exempt Investments 59

60 Personal Financial Planning Section Risk / Return Trade-Offs Between Differing Portfolios Portfolio A 6.61% Return 4.25% Risk* Portfolio B 6.61% Return 3.60% Risk* Portfolio C 7.06% Return 4.25% Risk* * Risk = one standard deviation 60

61 Personal Financial Planning Section What One Factor Most Influences Your Return? Source: Brinson, Singer, Beebower Your Asset Allocation 61

62 Personal Financial Planning Section Your desired rate of return Your risk tolerance Your time horizon What Most Influences Your Asset Allocation? StanVickie Stan and Vickie are different…their asset allocations will be different too. 62

63 Personal Financial Planning Section Importance of Your Desired Rate of Return The higher the rate of your desired return, the higher the risk you will most likely will have to take Desired Return Likely Risk 63

64 Personal Financial Planning Section Importance of Your Risk Tolerance The higher your risk tolerance the more aggressive you can be Risk Tolerance Be More Aggressive Be More Conservative 64

65 Personal Financial Planning Section Importance of Your Time Horizon Longer time horizons (5 or more years) can absorb the ups and downs of investing more heavily in stocks Shorter time horizons warrant investing more heavily in less volatile investments Time horizon Use more volatile stocks Use less volatile investments 65

66 Developing Your Investment Plan

67 Personal Financial Planning Section Use This Investment Planning Process What do you want? What will you have? Will you have a shortfall? What strategy will you employ? What actions will you take? Note: this process is applied to each of your investing goals 67

68 Personal Financial Planning Section What Do You Want? Take into account Your goal in todays dollars Number of years to your goal Expected inflation rate To arrive at What you want Be sure to include important others in deciding what you want. 68

69 Personal Financial Planning Section How do You Define Your Goals? Each goal will have its own time horizon For the period of accumulation For the period over which it will be spent Make a list and refine as you go along Start with broad ideas and work toward increasingly specific and measurable goals 69

70 Personal Financial Planning Section What Will You Have? Take into account Current assets set aside for your goal Number of years to your goal Future saving Expected return on your invested assets Expected future benefits To arrive at What you will have 70

71 Personal Financial Planning Section Where Should You Save First? 1.Your Employer 401(k) Plan (at least to the % that gives you the maximum employer match – free money for you) 2.Roth IRA using after-tax contributions or Traditional IRA using pre-tax contributions, depending on your circumstances* 3.Taxable accounts *Only Traditional IRAs can accept pre-tax contributions. Although both Traditional and Roth IRAs can accept after-tax contributions, it is generally preferable to use Roth IRAs. We will be covering IRAs in more detail later. You can use a Financial Calculator to determine which type of IRA is best for your particular situation. 71

72 Personal Financial Planning Section Why These Priorities? Taxable Account Roth IRA Using After-Tax Contributions Traditional IRA Using Pre-Tax Contributions Employer 401(k) Plan Salary$50,000 Pre-tax $$2,667 Tax at 25%$667 After-tax $$2,000 Employee contribution$2,000 $2,667 Employer match – assume 3% n/a $1,500 Total contribution$2,000 $2,667$4,167 % of salary contributed4.00% 5.33%8.33% Outcome$178,227What Happens? Vickie 72

73 Personal Financial Planning Section Why These Priorities? Vickie 73

74 Personal Financial Planning Section Why These Priorities? Vickie 74

75 Personal Financial Planning Section Consider Tax-Advantaged Accounts First Features Available Employer 401(k) Plan IRAs 529 Plan Tax-Deferred contributions (1) No (2) Tax-Deferred earnings (1) Employer contributions No Unlimited contributionsNo (3) Automatic saving and investing Wide-array of professionally managed funds Varies Self-direction of fund allocation No Immediate penalty-free withdrawalNoNo (1)No (1)Depends on the type of IRA used. (2)Some states allow you to deduct your contributions. (3)Some states limit contributions. 75

76 Personal Financial Planning Section Then Consider Taxable Accounts Features Available Employer DESPP (1) Employer DTP (2) Mutual Funds Brokerage Accounts Tax-Deferred contributionsNo Tax-Deferred earningsNo Employer contributionsNo Unlimited contributionsNo Automatic saving and investing No Wide-array of professionally managed funds No No Self-direction of fund allocation Buy Emplyr stock at a discount No Buy Emplyr stock without fees No Immediate penalty-free withdrawal (1) Discounted Employee Stock Purchase Plan (2) Direct Transaction Program 76

77 Personal Financial Planning Section Now Develop Your Preliminary Plan QuestionAnswers = Plan Your goal? Your risk tolerance? Your expected rate of return? Your time horizon? Current assets set aside for your goal? Future periodic savings/investing? Expected future benefits? Types of account(s) youll use? Asset allocation within account(s)? 77

78 Personal Financial Planning Section Then Calculate Your Expected Return* Major Asset Class Asset Allocation Historical Return Estimated Return Cash Bonds Stocks Hard assets __________% X 4% X6% X12% X8% __________% Total100%__________% * Calculated for each account you are using to invest your savings. 78

79 Personal Financial Planning Section And Then the Future Value of These Items* Contribution Toward GoalFuture Value Calculation Current assets set aside for your goal Calculate the future value of this amount invested at your expected rate of return over your time horizon Future periodic savings/investing Calculate the future value of these payments at your expected rate of return over your time horizon Expected future benefits Calculate the future value of this amount invested at your expected rate of return from the date of receipt to the end of your time horizon * Calculated for each account you are using to invest your savings. 79

80 Personal Financial Planning Section The Result is What You Will Have Take into account Current assets set aside for your goal Number of years to your goal Future saving Expected return on your invested assets Expected future benefits To arrive at What you will have 80

81 Personal Financial Planning Section Key Points to Remember Financial planning will help you clarify goals, strategies and action steps Determine whether you have too much debt and develop a plan to conquer it Make wise decisions about using debt Commit to saving and investing Save and invest early Pay yourself first Learn as much as you can about investing to develop a plan and invest according to your comfort level 81

82 Questions? [insert contact information here] Special thanks to Kevin Roach, CPA/PFS of Texas A&M University for contributing content.


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