PERSONAL FINANCIAL

MANAGEMENT
INTRODUCTION

Personal finance refers to the financial management of which an individual or a

family unit is required to make to obtain,budget, save, and spend monetary resources
over time, taking into account various financial risks and future life events.When
planning personal finances the individual would consider the suitability to his or her
needs of a range of banking products (checking, savings accounts, credit cards and
consumer loans) or investment (stock market, bonds, mutual funds) and insurance
(life insurance, health insurance, disability insurance) products or participation and
monitoring of individual or employer-sponsored retirement plans, social
security benefits, and income tax management.

The process of determining a person's financial needs or goals for the future and how
to achieve them. Personal finance involves deciding what investments would be most
appropriate under both personal and broader economic circumstances. All things
being equal, short-term personal financial planning involves less uncertainty than
long-term because, generally speaking, it is easier to predict one's future income.
Personal finance considers future income like pensions and expenditures such as
education or child support.

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 IMPORTANCE OF PERSONAL FINANCIAL
MANAGEMENT
Fulfilling Goals:
Managing your personal finances allows you to fulfill personal goals. If you want to
buy a new car, you need to start saving for it. That vacation to Cancun will not pay for
itself, either. Even far-off financial goals, such as buying a home or financing
retirement, will come to fruition with advance planning and careful money
management.

Avoiding Debt:
Being in debt means you owe money or other assets to someone else. Learning how to
manage your money better can help you get you out of debt or prevent you from
being in debt in the first place. Careful planning and tracking how you spend your
money will keep you from spending money you do not have on things you do not
need.

Reducing Stress:
If you stay awake at night thinking about the money you owe and wonder how you
will ever pay back your debts, it causes stress. Managing your personal finances not
only prevents debt; it gives you peace of mind because you know exactly what you
have spent and the amount you have saved.

PersonalEmpowerment:
When you gain control over your personal finances, you can feel a sense of
empowerment. You decide where your money goes, how you spend it, how much to
save, the best ways to build wealth and which goals you want to achieve. Managing
your finances makes you feel in charge of your life. After putting your finances in
order, you will no longer feel as though money runs your life.

Unlimited Career Options:

Even though your education or credentials make you an ideal candidate for your first
job, managing your finances may determine how far you'll go in your career. The
number of employers who use credit checks is increasing.
"Recent statistics are scarce, but when the Society for Human Resource Management
polled its members in 2006, 43 percent of their companies ran credit checks on some
or all potential hires," MSN Money contributor Liz Pulliam Weston reports.
Employers are using background investigations -- and credit checks -- to determine
who's best qualified for a job or promotion. If it comes down to two equally qualified
candidates, the one who demonstrates she's managed her finances well might be
picked over somebody who hasn't.

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Lower Interest Rates:
Buying your first home is a big step. Managing your personal finances is important
for a few reasons when it comes to getting the biggest bang for your buck. When you
have control of your finances, you can qualify for lower interest rates on a home,
which means you can pay less for your home and still enjoy your own space. Another
advantage of managing your finances is that you can sleep well at night knowing you
can make a mortgage payment that doesn't make you "house poor." House poor
means you spend all of your money -- income and discretionary cash -- on your home.

If you manage your personal finances well, you can save enough for a sizable down
payment, which can reduce your monthly payments even more. You also can afford to
make extra payments on your mortgage each year, creating a faster track to a
mortgage-free lifestyle.

Enjoy an Early Retirement:

For young adults, retirement planning sounds like a far away and distant goal.
However, if you manage your personal finances well, you could be sipping margaritas
on a tropical island or traveling the globe while you're still young enough to enjoy an
active lifestyle.
Once you're working and saving toward retirement, talk to friends and mentors about
your long-range goals. Bouncing ideas off others can help. Even if you want to work
until the traditional retirement age, managing your finances is important for lots of
reasons. You might want to start a family someday. Having an investment plan in
addition to your retirement savings is a smart way to go.

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 FINANCIAL PLANNING PROCESS

The Financial Planning Process consists of the following six steps:

1. Establishing and defining the client-planner relationship:

The financial planner should clearly explain or document the services to be provided
to you and define both his and your responsibilities. The planner should explain fully
how he will be paid and by whom. You and the planner should agree on how long the
professional relationship should last and on how decisions will be made. Let the
planner know how you best communicate and in what form you would like
communication to flow (email/phone/in person. Also ask what your responsibilities
are as far as providing complete and accurate information in a timely manner.

2. Gathering client data, including goals:

The financial planner should ask for information about your financial situation. You
and the planner should mutually define your personal and financial goals, understand
your time frame for results and discuss, if relevant, how you feel about risk. The
financial planner should gather all the necessary documents before giving you the
advice you need.

3. Analyzing and evaluating your financial status:

The financial planner should analyze your information to assess your current situation
and determine what you must do to meet your goals. Depending on what services you
have asked for, this could include analyzing your assets, liabilities and cash flow,
current insurance coverage, investments or tax strategies.

4. Developing and presenting financial planning recommendations

and/or alternatives:
The financial planner should offer financial planning recommendations that address
your goals, based on the information you provide. The planner should go over the
recommendations with you to help you understand them so that you can make
informed decisions. The planner should also listen to your concerns and revise the
recommendations as appropriate. In this process, it will be made clear what steps
require the planner to complete and follow up and what steps require you, the client,
to complete and follow up on.

5. Implementing the financial planning recommendations:

You and the planner should agree on how the recommendations will be carried out.
The planner may carry out the recommendations or serve as your "coach,"
coordinating the whole process with you and other professionals such as attorneys or
stockbrokers.

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6. Monitoring the financial planning recommendations:
You and the planner should agree on who will monitor your progress towards your
goals. If the planner is in charge of the process, she should report to you periodically
to review your situation and adjust the recommendations, if needed, as your life
changes.

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COMPONENTS OF A PERSONAL FINANCIAL PLAN

 Cash Flow Management:

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

 Tax Planning and Management:

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

 Risk Planning and Management:

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

 Investment Planning and Management:

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

 Retirement Planning and Management:

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

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 CASH MANAGEMENT AND BUDGETING

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

Managing Cash & Savings

1) Financial Institutions
 Traditional financial institutions include banks, savings and loan associations,
savings banks and credit unions.

 Many different accounts are available from these institutions:

o Demand Deposit Accounts – Withdrawals may be made whenever

demanded by the accountholder (checking accounts)

o Time Deposit Accounts – Deposits in these accounts are intended for

longer accumulation. An Accountholder may be required to give a
specific notice prior to withdrawal (Passbook or Regular Savings
Accounts)

o MMDA Accounts – Money Market Demand Accounts are similar.

o MMMF Accounts – Money Market Mutual Funds pool funds from

many investors and use these funds to purchase short term securities
such as commercial paper, etc. They also offer a rate of return and easy
access to funds through withdrawals or checking.

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

2) Developing Savings Habits

A portion of your financial assets should be kept liquid and readily accessible for day-
to-day needs and emergencies. Most planners believe that you should maintain such
an account in an amount equal to at least three to six months’ living expenses.

Once this fund is established, you may then begin to consider the funding of more
long-term savings goals. The most appropriate savings vehicle for these savings goals
will vary, depending on time horizon of the savings goal; risk tolerance; etc.
However, as a rule of thumb, a savings goal of 15% of gross income is a good target,
although you may not be able to achieve this goal all at once. Some savings vehicles
available through traditional financial institutions or through brokers are:

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3) The Power of Compound Interest
How much you earn on your accumulated investment funds will be determined by
several factors:

 Your initial Investment and subsequent additional investments

 The amount of time the money is left on deposit
 The rate of interest being paid
 The method of interest calculation

The future value of your investment can be determined by the use of a simple
calculation.

Future Value is the amount to which today’s investment will grow over a given
period of time at a specific rate of interest. This process is referred to as
"compounding."

Example
Assume that you were to make a Rs.2000 deposit into a Certificate of Deposit earning
5% interest per year. At the end of 20 years, total deposits would have been Rs.40,000
(20 years x Rs.2000 per year). However, the total account value would be Rs.66,132,
due to the compounding of interest over that period of time.

To apply this to a goal-setting problem, if you were to identify a savings goal of

Rs.20,000 as down payment for a home in five years, (with Rs.5000 already saved),
you could not simply divide the Rs.15,000 remaining accumulation goal by 5 to find
out how much you would have to save per year to reach your goal. This process
would ignore the interest factor, for which we will use 10%.

FUTURE VALUE = AMOUNT INVESTED X FUTURE VALUE FACTOR

This future value factor may be arrived at by using a financial calculator, or by using
a Future Value Table. To use this Table, locate the factor (1.6105) which lies at the
intersection of 5 on the vertical axis (for 5 years); and locate 10 on the horizontal axis
(for 10% interest).

The factor (1.6105) is then inserted into the formula:

FV = Rs.5,000 x 1.6105 = Rs.8,052.50

Thus, your Rs.5,000 will be worth Rs.8,052.50 in 5 years. Subtracted from our total
goal of Rs.20,000 there is still Rs.11,947.50 needed. The second step of our problem
involves using the future value formula again to determine how much savings per
year will be necessary (still at the 10%) for the 5 year period in order to reach the
Rs.11,947.50 goal.

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A second time value formula involving a cash flow (sometimes called an annuity)
can be used:

YEARLY SAVINGS = AMOUNT DESIRED DIVIDED BY FUTURE VALUE

ANNUITY FACTOR

This computation uses a Future Value of an Annuity Table. You againlocate the
intersection of 5 years and 10 percent interest with a factor of 6.1051. Plugged into
the formula, the computation becomes:

YS = Rs.11,947.50 DIVIDED BY 6.1051 = Rs.1,956.97

So, you would have to save Rs.1,956.97 per year for five years, invested at 10%
interest to reach your goal of Rs.11,947.50.

4) Present value calculation

Present Value is the value today of an amount to be received in the future; or the
amount you would have to invest today at a given interest rate over the specified time
period to accumulate the future amount. This process is known as "discounting", and
is the inverse of compounding.

Example
Present Value calculations are frequently used in retirement projection
calculations. For example, if you are 35 years old and wish to accumulate a
Rs.300,000 retirement fund by age 60 (25 years from now), you would use a
Present Value Table.

PRESENT VALUE = FUTURE VALUE X PRESENT VALUE FACTOR

If we assume a 25-year investment at 7% the solution would look like this:

PV = Rs.300,000 x .1842 = Rs.55,260

This is the lump sum you would have to deposit today to reach your goal with no
further contributions.

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Another example involving present value deals with regular payments.

Example
Suppose you this is in the fall of your son or daughter's senior year in high school
and you want to know how much money you need to have today in order to make
tuition and fee payments of Rs.18,000 at the beginning of each of the four .

To do this, use a Present Value of an Annuity Table.

PRES. VALUE = ANNUITY VAL. X PRES. VAL. OF AN ANNUITY FACTOR

Enter the Present Value of an Annuity Tableat four years and 12% interest and
obtain the factor of 3.0373.

Therefore, if you have Rs.54,671.40 invested today at 12% interest, you will be
Able to withdraw Rs.18,000 one year from today and foreach of the following
three years.

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 PREPARATION OF PERSONAL FINANCIAL
STATEMENTS

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

The two forms we will be working with are the Personal Financial Statement; the
Personal Budget.

The Personal Budget

Why Prepare a Personal Budget?

A Budget can be used as a tool in identifying how and when money is being spent. It
can help to identify cash flow problems and can also identify dollars which may be
redirected toward achieving financial goals.

Steps in Budgeting
1. The first step is to record historical information as to income. This information
will come from pay stubs or statements or tax returns.

2. The next step is to record historical information concerning your personal

expenses. This information will be found in your cancelled checks; checkbook
registers; paid receipts (cash); credit card statements and/or tax returns.

3. You may wish to segregate your expenses by type. ("Fixed" expenses refer to
payments which are equal and non-varying each payment period and
"variable" expenses involve payments that vary in amount from one time
period to the next.)

4. Once existing patterns are identified, you can identify those areas which you
may wish to target for change.

5. The next step in the budgeting process involves preparing projectedincome

and expenses for the next budgeting period (usually one year). You should
include any targeted changes you have identified in Step 3.

6. Next, you will maintain Records of income and expenses as they occur.

7. Periodically compare actual results to desired target. Make changes as needed.

8. A budget will only help you achieve your goals if is honest; if it is used; and
if adjustments are made, as needed. It also makes sense to get into the habit
of "paying yourself first" by making the first check you write once you get

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 paid to yourself to be deposited to you savings and investment program. If you
wait to see what is left over, it is usually nothing!

Personal Budgeting Worksheet

(Period covering _______________to ________________)
Item Historical Target Actual Difference
Household Expenses
Food
Clothing
Transportation
Personal
Insurance
Professional
Debt Repayment
Miscellaneous
Savings and Investment
Grand Total

The Personal Financial Statement

Why Prepare a Personal Financial Statement?

The Financial Statement is like a snapshot of your financial condition as of a certain
date. The categories on a balance are assets, liabilities, and net worth. Financial
statements should be prepared at least once per year. The Personal Financial
Statement will include the following information:

Assets
Assets are the things that you own. They are often grouped into broad categories:

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

 Investment Assets – Assets which are held for their financial return, rather
than for personal use. Stocks, Bonds, Mutual Funds, etc.) These assets
generally appreciate (increase) in value.

 Real Property – Land and things attached to it (house, garage, etc.)

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  Personal Property – Movable property usually held for personal use
(automobile, furniture, clothing, etc. These assets generally depreciate
(decrease) in value.

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

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

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

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

Utilizing and Analyzing the Information on your Personal Financial Statement

Important areas to examine are:
 Net Worth – If your family’s net worth is less than zero, than you are
insolvent. A family’s net worth should increase over time.

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

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

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 UNDERSTANDING THE USE OF CREDIT

Appropriate Use of Credit

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

 Safety/Convenience – Consumer does not need to carry large amounts of cash,

which could be lost or stolen . Also, recourse is provided for unsatisfactory
purchases and returns can be re-credited to the account.

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

 Record-Keeping – Credit borrowing provides an itemized record of all

transactions.

 Opportunity – Consumer can make unanticipated purchases when cash

resources are not available.

 Facilitation of Transaction – Consumer can make certain purchases indirectly

by telephone or Internet or directly such as automobile rental; airplane tickets,
etc. when other payment forms are not practical.

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

Inappropriate Use of Credit

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

 The biggest problem with credit is the tendency to overspend.

 Credit should not be used for routine basic living expenses or impulse
purchases

 Credit should also not be used for the purchase of short-lived goods and
services. (Rule of thumb: an item purchased by credit should not be used up
sooner than the bill is paid off!)

 Monthly debt repayment should not exceed 20% of monthly take-home pay.

 High interest costs on unpaid balances can accumulate rapidly.

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Computation of Finance Charges on Credit Accounts

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

 Calculation of Interest rate on Unpaid Balances – May be fixed or variable.

Issuers must disclose the "APR" (Annual Percentage Rate) and the "PIR"
(Periodic Interest Rate) for each billing cycle.

 Computation of Unpaid Balance – The method by which a card issuer

calculates the unpaid balance on an account. This balance multiplied by the
periodic interest rate determines the finance charge, so it is very important!

1. Average Daily Balance Method – Each day the issuer subtracts any
payments and adds new purchases to the account balance. These
balances are they added together for the billing period and divided by
the number of days in that cycle.

2. Previous Balance Method – The issuer charges interest on the

balance outstanding at the end of the previous billing cycle. This is the
most expensive method for the consumer since interest is charged on
the outstanding balance at the beginning of the billing period.

3. Adjusted Balance Method – The issuer starts with the previous

balance, subtracts any payments or credits, and charges interest on any
remaining unpaid amount.

4. Past Due Balance Method – With this method the issuer does not
charge any interest for cardholders who pay the account in full before a
specific period of time; otherwise, the finance charge is imposed under
one of the three preceding methods.

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

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

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

 Acceptance – Some cards are more widely accepted than other cards

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 INCOME TAX PLANNING

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

Income tax planning encompasses several areas to include:

 Understanding the structure and operation of our tax laws
 Calculation and filing of federal income tax returns
 Planning to minimize taxes
 Other forms of personal taxation

Calculation and Filing of Income Tax Returns

There are several factors, which will determine the amount of income tax you will
pay:

 Filing status
 Taxable Income (Gross)
 Allowable adjustments to income
 Allowable deductions to income
 Exemptions

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

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Gross Income Defined
The definition of income under the Income Tax Act is of an inclusive nature, i.e.

Apart from the items listed in the definition, any receipt which satisfies the basic
condition of being income is also to be treated as income and charged to income tax
accordingly. Income includes:-

 Profits or gains from business or profession including any benefit, allowance,

amenity or perquisite obtained in the course of such business or profession.

 Salary Income including any benefit, allowance, amenity or perquisite

obtained in addition to or in lieu of salary.

 Dividend income

 Winnings from lotteries, crossword puzzles, races, games, gambling or

betting.

 Capital gains on sale of capital assets.

 Amounts received under a KeyMan Insurance Policy i.e. a life insurance

policy taken by a person on the life of another person who is or was the
employee of the first mentioned person or is or was connected in any manner
whatsoever with the business of the first mentioned person.

 Voluntary contributions received by a religious or charitable trust or scientific

research association or a sports promotion association.

Sources of Income Excludable FromTaxation

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

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

Thus income form basic operations on land like cultivation, growing crops
etc. and secondary operations like removal, digging, etc. can be classified

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 as agricultural income and is exempt from tax. However, income from sale
of trees, breeding livestock, fishing activities, poultry farming cannot be
classified as agricultural income and is not exempt from income tax.

B. Receipt by a member out of a HUF income

Any sum received by a member of a Hindu Undivided Family from out of
the income of the family as well as the income received by an individual
member from out of the income of the impartial estate is exempt.
Impartible estate means property which cannot be disposed off or divided
by the holder of the property.

An HUF is separately taxed on its income. The rate of tax levied on a

Hindu Undivided Family is quite high. Therefore, in order to avoid the
same income from being taxed twice, distribution of HUF income amongst
members is exempt from Income Tax.

C. Share of income of a partner from a firm

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

D. Casual or non-recurring receipts

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

However the following income will not be treated as casual or non-

recurring:-

 Capital gains

 Receipts arising from business or from exercise of profession

or occupation.

 Receipts by way of addition to the remuneration of an

employee.

E. Amount received under a life insurance policy- including the bonus

Any amount received under a life insurance policy including a bonus
either on maturity of the policy, or otherwise, is exempted from tax.
However, this exemption is not available to a KeyMan Insurance Policy.

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

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

H. Income of a minor upto Rs.1500
Any income which arises to a minor child of an assessee is added or
clubbed to the parents income under Section 64(IA) of the Act. Section
10(32) however gives exemption from such clubbing up to a maximum of
rs.1500 annually per child.

I. Dividend received by a shareholder

Any income received by way of dividend from a domestic company, or
from UTI or from a recognized mutual fund by a shareholder/unit holder is
fully exempt from tax.

J. Awards and Rewards

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

K. Pensions received form gallantry award winners.

Family pension received by individual who has been in the service of the
Central or State Government and has been awarded “ParamVir Chakra” or
“MahaVir Chakra” or “Vir Chakra” or other notified gallantry award or by
members of his family is exempt from income tax.

L. Interest incomes of certain types

The following interest income is exempt from income tax:-
 Interest on notified securities, bonds, certificates, deposits, etc.
 Interest on notified Capital Investment Bonds
 Interest on Relief Bonds
 Interest on notified Bonds in the hands of non-residents
 Interest on notified savings certificate
 Interest on Gold deposit bonds,1999
Deductions From Adjusted Gross Income
A. An individual assessee can claim a deduction (u/s 80 CCC) for any amount
paid or deposited by him in any annuity plan of the Life Insurance
Companies for receiving pension from a fund set up by the said corporation.
The deduction is restricted to a maximum of rs.10000.

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B. An assessee (u/s 80 D) is entitled to a deduction up to rs.10000 a year in
respect of the premium paid by him/her by cheque for insurance:

a) On his health or on the health of his spouse or dependent parents or

children, and
b) In case of a Hindu Undivided Family on the health of any member
of such family.

Where any of the aforesaid persons is a senior citizen(i.e. one who has attained
65 years of age at any time during the previous year), the aforesaid limit has
been increased upto rs.15000.

C. Section 80DDB has been inserted to specifically provide a separate

deduction for expenditure incurred for the medical treatment for the
individual himself or to his dependent relative or any member of the Hindu
undivided family in respect of diseases or ailments as maybe specified in
the rules. The amount of deduction shall be limited to a maximum of
Rs.40000. Moreover assesse or any member is a senior citizen (i.e. at least
65 years of age at any time during the previous year), then a fixed deduction
of rs.60000 shall be available. The amount of deduction available shall be
further reduced by any amount received from an insurer for medical
treatment.

D. Any taxpayer can claim a deduction (u/s 80 G & u/s 80 GGA) in respect of
donations made to certain funds, charitable institutions.

E. An assesse can claim a deduction for the interest received on the following
Securities:

 Interest on any securities of the Central or any State Government;

 Interest on deposits under such National Deposit Scheme as may

be framed by the Central Government and notified by it in this
behalf in the official gazette;

 Interest on deposits under the Post Office (Monthly Income

Account).

F. An assesse shall be entitled to a deduction, from the amount of income tax

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

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

So, now we complete our tax calculation as follows:

Gross Income

Less: Adjustments to Gross Income

Equals: Adjusted Gross Income (AGI)

Less Larger of Itemized or Standard Deductions

Less Exemptions

Equals Taxable Income

Times: Applicable Tax Rate

Equals Tax Liability

Less Tax Credits and Prepayments

Equals Tax or Refund Due

21
 TAX PLANNING AND ITS ROLE IN THE FINANCIAL
PLANNING PROCESS
Taxpayers are always seeking ways to eliminate or at least reduce their income tax
burden. There are some strategies, when used in conjunction with the overall financial
plan, which can accomplish these goals.

Some popular tax-savings strategies are:

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

o Are you aware of all available exemptions, deductions and credits to

which you are entitled?

o Is your present taxpayer status (joint return, separate return, Head of

Household, etc.) best for you?

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

o If self-employed, have you considered which form of business

structure (Sole Proprietorship, Partnership, etc) is most advantageous
from a tax perspective?

2) Acceleration and Deferral Techniques

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

o Deferral: Deferring or postponing income may also result in tax

savings. If taxable income is anticipated to be less in the next taxable
period, deferring income into that period could result in lower taxes.
Conversely, deferring expenses into the next taxable period would

22
 make sense if taxable income was anticipated to be higher than in the
current income period.

3) Utilization of Non-Taxable Employee Benefits

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

o Group medical and dental insurance (benefits received are not

considered taxable income.)

o Group term life insurance (death benefits of up to Rs.50,000 in most

cases, are exempt from taxation.)

o Group accidental death and dismemberment, travel accident and

related plans.

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

o Making a gift of income–producing property (such as stock, savings

bonds, certain real estate, etc.) In this case, all future income will be
taxed to the recipient, not the donor. It is important to note that this
action may have Gift Tax implications, which should be discussed with
your personal tax advisor.

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

o The opposite of income shifting is deduction shifting. This is

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

5) Tax-Managing Your Investment Portfolio

o As an investor, you may be able to time investment sales in order to
maximize your tax advantage. If you have capital gains on securities or
other investment property, these gains may be offset by selling another
security you own for a loss. This involves the planning in terms of the
timing of the purchase and sale of these securities so that they fall
within the same tax calculation period.

23
 o "Tax exchanges" are available which will permit the sale of a security
for a loss, and yet maintain a similar investment position. (For
example, if you originally purchased a technology stock at Rs.10 per
share, but the stock had now declined to Rs.5 per share, you could sell
this stock, taking advantage of the loss for income tax purposes and
immediately purchase a different technology stock; thereby keeping
your position in a technology investment. (Note: tax laws are
somewhat complicated, so you should consult with your tax
professional for personal advice before undertaking this strategy.)

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

Example
Suppose, if over time, you had purchased shares of a particular
stock as follows:

100 shares at Rs.20 per share in 1985

50 shares at Rs.70 per share in 1990

100 shares at Rs.80 per share in 1995

The value of the stock is now Rs.70 per share. If you wish to sell 50 shares, you
may sell shares which would result in a gain (those purchased in 1985); no loss or
gain (those purchased in 1990) or a loss (those purchased in 1995).

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

6) Making Charitable Contributions

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

o Gifts of appreciated property such as stock or real estate (These gifts

would generally be deductible at fair market value on the date of the
gift, with no capital gain consequences to the donor.) This may,
however, trigger Alternative Minimum Tax consequences.

o The establishment of Charitable Remainder Trusts in which property is

transferred to the trust, with the donor receiving and income stream
from the investment, and the charity receiving the property. The

24
 taxpayer receives a current tax deduction for the value of the
“remainder” interest that the charity is receiving.

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

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

Another investment potentially excludable from taxation is Series EE Bonds, when

used for higher education purposes (Certain limitations apply.)

9) Tax Deferred Investing

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

o Qualified employer-sponsored retirement plans

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

o Life Insurance Cash Values and the interest/investment return they

receive are not subject to current income taxation. If values remain in
the policy until the death of the insured, they pass as a portion of the
death benefit to the beneficiary with no income tax consequences ever!
If values are withdrawn during the life of the insured, any gain over

25
 and above the initial investment of premium is taxed as ordinary
income. (For more information, see Insurance Module.)
o Deferred Annuity policies also feature the deferral of tax on
investment growth until the policyholder withdraws these funds. (For
more information, see Insurance and Retirement Modules.)

10) Tax Planning Wisdom

Tax planning is very important; however, it should never be over-emphasized at the
expense overall financial goals and objectives. In some instances a strategy, which
results in tax-savings also results in some loss of flexibility, control, or some other
advantage. For example, tax-favored retirement plans offer deferral of taxes until
retirement; however, they impose strict regulations and penalties which prevent the
use of these funds prior to retirement age (59 ½ in most cases). In general, if a
strategy to save taxes does not make sense, other than for tax purposes, it should not
be implemented. Also, a tax adviser should generally be consulted concerning the
overall implications of any tax-savings strategies.

26
 INSURANCE PLANNING AND RISK
MANAGEMENT

Risk Management is the cornerstone of any financial planning effort. It makes no

difference how elaborate or effective the investment portfolio, the retirement plan, or
the estate plan, if you have not taken the necessary steps to eliminate risk, all
remaining planning efforts could be pointless. Risk management through the wise use
of insurance removes the concern for the unknown from a financial plan.

How Does One Manage Risk?

There are four basic techniques for managing risk:
 Risk Avoidance - This technique involves the avoidance of exposure to loss;
either by not owning specific property that could be exposed to loss; or by not
engaging in a specific activity which could create liability.

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

 Risk Reduction/Loss Management and Control - This technique involves

lowering the probability of a particular hazard occurring; and lessening the
severity of the hazard by taking some positive action.

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

 Risk Assumption/Retention - This technique involves the acceptance of the

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

27
 Example
Choosing not to insure a 15-year-old car with a value of less
than Rs.1,000 for collision coverage is an example of Risk
Assumption.

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

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

 Risk Transfer - This technique almost always involves some form of

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

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Life Insurance
The first application of Risk Transfer through insurance that we will address is the
risk of death. Death always involves a loss, but in its financial sense, a loss due to
death is measured in terms of incomplete financial goals and objectives.

How Do I Determine My Potential Financial Loss Due to Death?

Some of the financial needs that may be created by a death are as follows:

 Final personal expenses – final medical expenses, funeral, burial, etc.

 Estate / death expenses – estate settlement costs to include federal and state
estate taxes, probate, legal, accounting, appraisal fees, etc.

 Family income – support for surviving spouse and dependent children

 Additional expenses – necessary additional household services, childcare, etc.

 Liquidation of debts – payoff of mortgage, auto loan, credit cards educational

loans, etc.

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

 Liquidity – emergency fund; necessary immediate cash flow

 Bequests – church, school, family members, friends employees, charities

 Funding of established financial goals – completing college funding; purchase

of second home, pay off the mortgage, etc.

There may also be additional financial needs of a business nature such as funding the
transfer of an existing business through; or protecting a business from the loss of an
owner/key-employee.

How Much Life Insurance Should I Buy?

There are many formulas used in the calculation of life insurance need. The most
meaningful methods consider both financial needs created at death and what available
resources exist to address these financial needs. You should also remember that your
needs will vary at different stages during your life.

The first step is to establish the rupee value of the needs. Some of these may be
expressed as lump sums; others as cash flow.

The next step is to identify what available resources may be used to eliminate or
reduce the financial shortfall. These resources will vary greatly from family to family,
but may include:

 Other sources of income from family members

29
  Survivor benefits (Social Security, employer-sponsored plans, etc.)

 Assets that may be easily liquidated and used to meet the established needs

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

Kinds of Life Insurance

There are several types of life insurance; each with numerous variations. The type of
coverage that is best for you depends on a number of factors. First, a brief familiarity
with the basic types will be helpful:

1) Term Insurance:
Term is insurance that is purchased for a certain period of time (its “term”). During
that term, premiums are paid, and a death benefit will be received, if death occurs.
There is no cash value build-up. Premiums on term plans are considerably less
expensive than with other plans.

At the end of the term, the insured will be faced with one of several choices,
depending on the type of term policy purchased. If the need for insurance still exists,
the insured will have to apply to purchase a new term policy; generally requiring
evidence of insurability (good health); or may be allowed to continue with the
existing plan, but at a considerably higher premium. Term plans are sometimes
compared to renting a home. During the time premiums is being paid (“rent”); the
insured receives the benefit of coverage. Once the premium period has ceased, the
insured must “move” or pay higher “rent”. There is no “equity” (cash value).

2) Whole Life:
This is the oldest form of permanent/cash value life insurance. It features a
guaranteed premium; a guaranteed cash value; and a guaranteed death benefit.
The cash value earns a minimum guaranteed rate of return, and may also receive
dividends or additional interest.

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

How Do I Decide Which Company To Use?

Once the amount of insurance needed, and the type of policy desired is determined,
the next decision is the selection of a company. Important considerations are:

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

30
  Comparative Policy Benefit- The policy provisions, guarantees, historical
performance are but a few of the factors which may vary from company to
company and should be considered.

 Financial Strength of the Issuing Company- The insurance company’s

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

 Availability of Local Professional Service Personnel - You will find the

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

Life Insurance Features

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

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

 The growth of cash value within the life insurance contract grows on a tax-
deferred basis. So, no taxes are currently due. This is true so long as the policy
remains in force (as long as statutory requirements are met.)

 If the cash value is ultimately withdrawn or the policy is surrendered prior to

the death of the insured, the withdrawal is income tax free up to the total basis
(premiums paid) of the policy. Thereafter, the gain is taxed as ordinary
income.

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

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

 Death proceeds payable to a named beneficiary do not become part of the

estate, and generally are not subject to estate debts but may be subject to estate
tax.

 In most states, creditors are prevented from penetrating accumulated cash

values in life insurance policies in the event of lawsuit or bankruptcy.

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Health Insurance
The second application of Risk Transfer through insurance is the risk of
overwhelming expenses related to heath conditions. These expenses can fall into
several categories.

What Risks Should I Consider In the Area of Health Insurance?

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

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

 Managed Care Plans

 Indemnity Plans

2) Disability Income Insurance

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

At Age 27 = 2.7 times greater

At Age 42 = 3.5 times greater
At Age 52 = 2.2 times greater

32
How Do I Know How Much Disability Insurance I Need To Purchase?
Calculating the amount of disability insurance that may need to be purchased is a
process similar to the calculation performed in determining life insurance need. The
first step is to determine the amount of income that is required for family support.
You may want to inflate this number somewhat to make allowance for potentially
higher living expenses in the event of a disability, such as extra help around home;
additional medical services, etc.
The second step is to offset this need with any income available from sources other
than employment (wages of other family members, rental or investment income, etc.).
This calculation will give you a good idea of how much disability insurance you will
need to purchase. Most carriers limit coverage to approximately 60% to 65% of pre-
disability earnings. Your premiums will be based on your age, sex, occupation,
income and the policy provisions you select.

Also, keep in mind that if you are paying your disability premium from your personal
resources, when the benefits are paid to you, they will not be taxable. If, however,
your employer is paying the premiums on your behalf, benefits will be taxable when
received.

Property and Liability Insurance

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

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

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

How Are These Policies Structured

All of these policies contain two sections, and sometimes a rider:

o Section I – Property Loss Exposure which covers a loss of any of the

following due to a peril stated in the policy:
A. - Dwelling
B. - Other Structures
C. - Personal Property
D. - Loss of Use
o Section II – Liability Loss Exposure (E) which covers personal
liability (lawsuit protection) and Medical Payments to Others (F)

33
 o The Personal Property Floater (PPF) is a rider which provides
additional protection for items not adequately covered in a standard
homeowners policy, such as furs, jewelry, photography equipment,
silverware, art, antiques, musical instruments, and collections.

Who Is Covered Under This Policy?

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

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

On What Is Coverage Based?

Generally coverage on the dwelling includes the amount necessary to repair, rebuild
or replace an asset at today’s prices is covered, if the homeowner keeps the home
insured for at least 80% of the amount it would cost to rebuild currently, excluding
land value. In periods of inflation, you should increase coverage annually to keep up
with inflation or purchase an inflation rider, which automatically adjusts coverage for
inflation.

Contents may be covered on actual cash value basis, or on a replacement cost basis
(also taking depreciation into account.) Full re-imbursement may be available for a
higher premium.

Are there Other Things I Should Consider In Structuring My Policy?

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

o You may wish to consider purchasing an Inflation Rider that will

increase the cost of your policy somewhat, but will keep your coverage
at current levels.

o Some covered items will require an additional policy rider in order to

be adequately covered, such as your home computer; antiques or art;
furs, jewelry and some collectibles.

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

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Automobile Insurance

How Are Auto Policies Structured?

State law determines whether auto coverage will be handled on a standard policy
basis or the "no-fault" basis.

Some of the factors affecting premium are:

o Geographic Location of Coverage ("Rating Territory") - Some

geographic locations have worse claims experience than others;
therefore, premiums are higher in these areas.

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

o Personal characteristics of Drivers – Age, sex, marital status all affect

premiums. Young drivers are in higher classes than others.

o Type of Auto to be Insured – An auto’s classification as "standard",

"intermediate" or "high" performance affects premium. Premiums are
also higher on sports vehicles and vehicles with rear engines.

o Driving Record – A driver with traffic tickets, accidents or arrests for

DUI will incur higher rates than safe drivers.

35
 INVESTMENT PLANNING

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

Ask yourself these questions:

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

 What is (are) my investment goals?

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

 What is my time horizon?

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

 How much will be needed to fund my goals?

Future Value methods may be used to determine how much is needed.

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

36
Selecting an Investment
Although there are numerous factors that may be considered, some of the most
important are:

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

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

 Risk of Principal – If the investment selected performs poorly, the amount of

money which was invested can be lost, in part or in whole.

 Market/Volatility Risk – The value of the investment selected may move up

or down due to changes in the particular financial market your investment is
participating in.

 Purchasing Power Risk – This is uncertainty over the future purchasing

power of the income and principal from a selected investment. This is created
by changes in the general price level of the economy.

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

Example

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

37
  Tax Risk – This involves the potential tax consequences involved with a
particular investment to include federal and state income, estate, inheritance
and gift taxes.

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

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

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

Another factor affecting Rate of Return is the potential effect of compounding

(earning interest on interest). If interest, dividends, etc. are allowed to remain in the
investment and in turn, receive the benefit of future growth, the result is
compounding.

The interaction between these first two factors creates the Risk/Return Trade Off. The
amount of risk associated with a given investment vehicle is directly related to its
expected return. This is known as the "Universal Rule of Investing". So,
theoretically, the more risk you are willing to take, the higher return you should
expect to receive. To give you some perspective, a "risk-free" rate of return would be
an investment that provides a positive return with zero risk (i.e. a 90-day US Treasury
bill). This is often used as a benchmark against which other investments are
measured. As risk is increased, so should return potential.

3) Impact of Taxes on Return

It has been said that it doesn’t matter what you get; only what you get to keep! For
this reason, it is very important to differentiate between the Return received from an
investment and its "after-tax" Return.

There are several considerations here:

 An investment may yield income that is currently taxable as ordinary income,

such as interest on Certificates of Deposit, corporate bonds, etc. In this case,
the After-Tax Yield is going to be less than its Current Yield (interest rate).
This can be determined by multiplying the current yield by "1" minus the
investor’s income tax rate.

38
 Example

If Mr. Fletcher, who is in the 28% tax bracket, invested in a Certificate of Deposit
which was paying 6% interest, his After-Tax Yield would look like this:

After-Tax Yield = Current Yield (1 – Tax Rate)

= .06 (1 - .28)
= .06 (.72)
= .0432, or 4.32%

So, Mr. Fletcher really didn’t make 6% on his investment; he made 4.32%,
because the rest went to pay taxes.

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

Example

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

 An investment may yield returns that are taxable only when realized and
recognized as capital gains. This time, Mr. Fletcher, purchased shares
common stock of ABC Pharmaceutical Company. The stock has paid no
dividends, but it has increased in price from $10 per share to $20 per share
during the past year. In this situation, Mr. Fletcher will not have a taxable
event until he sells his shares, since he has not "realized" his capital gain of
$10 per share yet.

Further, due to favorable capital gains treatment, when the shares of stock are
finally sold, the tax rate will be lower than the tax rate would have been had
the shares produced dividends which would have been taxed as ordinary
income.

These were very simple examples, when in fact, the implications of tax
treatment of investment income can be very complex. Your professional tax
and investment adviser will assist you in determining the impact of your
investment positioning on your personal tax situation.

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

 Marketability refers to the degree to which there is an active market in which

an investment can be readily traded.

 Liquidity refers to the ability to readily convert an investment into cash

without losing any of the principal invested. An investment with liquidity has
a highly stable price.

Some investments are neither marketable nor liquid; others are marketable, but
not liquid; or liquid, but not marketable; while others are both marketable and
liquid.

Example

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

Although marketability and liquidity are desirable, it is often necessary to have a

"trade-off", since highly marketable or liquid assets usually yield less than less
marketable or illiquid investments. So, an important question for you to consider, is
"Is marketability or liquidity important enough to give up some yield?" This, of
course, depends on your overall situation.

5) Diversification
Diversification is an important investment policy to consider in constructing a
portfolio. It refers to the defensive strategy of spreading investment dollars into
several different investments in order to minimize risk. There are numerous types of
diversification. You might diversify between stocks and bonds (equity and debt);
between liquid and non-liquid investments; between one investment objective and
another; etc.

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

40
Kinds of Investments
There are many investment vehicles available. But in general, all forms of
investments may be divided into "Debt" and "Equity" investments. Anytime you
allow someone to use your money to make money, it is considered a "debt"
investment. This category would include bank certificates of deposit; bonds (of all
types); fixed annuities; cash value of whole or universal life insurance; notes
receivable; etc. "Equity" investments actually allow you to take an ownership position
and include stocks, real estate, tangible assets such as gold; and collectibles such as
art, antiques, etc.

Debt investments usually involve little, if any, risk of principal, and low to moderate
returns. These returns are derived from interest and/or dividends. Equity investments
expose all of your investment capital to the risk of losing your principal, and generally
derive most of their investment return from appreciation of the value of the
underlying asset (capital gains).

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

 Government Securities
 Treasury Bills
 Commercial Papers
 Public Sector Unit Bonds

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

What Types of Bonds are there?

Bonds may also be classified as "callable" or "non-callable". Callable bonds contain

a provision allowing its issuer to retire the bond earlier than its maturity date. This
right must be specified in the original bond offering, and most callable bonds prohibit
recall during a specified period of time. The issuing corporation can usually exercise
the call provision at any time after a specified date. A "call premium" (such as one
year’s interest) is generally payable to the investor, if the bond is called.

41
Some of the different types of bonds issued in the Indian Market are as follows:

1) RBI Relief Bonds: These are bonds issued by the Reserve Bank Of
India and are fully backed by the faith and credit of the Indian
Government. they are sold in Rs.1000 denominations and all issues are
non-callable. The interests earned on these bonds are exempt from
income tax.

2) Infrastructure Bonds/ Tax Saving Bonds: This bond is issues

specifically for infrastructure development on the country. The
individuals investing in such types of bonds get rebate under Section
88. The Government has given permission only to IDBI and ICICI to
issue such bonds. The interest received from these bonds is subject to
tax.

3) Encash Bonds: This bond is designed to give instant liquidity anytime

after one year, across the counter, to the investors in case of need.
NRIs are not eligible to invest in this bond.

4) Regular Income bonds: This bond is designed in such a way that an

individual will get the interest payment regularly till the maturity of the
bond. The payment options generally are monthly, quarterly, half-
yearly or yearly.

5) Floating Rate Bond: This bond is designed to provide returns to the

investors linked to the yields on Government of India securities.

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

 Common Stocks
 Real Estate
 Puts and Calls/Options
 Commodities

Common Stocks
What Are the Investment Characteristics of Common Stock?
When you purchase a "share" of stock, you become a fractional owner interest in that
company. As a common stockholder, you will actually have an ownership position in
the company. You may receive dividend income, but only after all other debt
obligations have been met by the company. Also, if the value of your share of stock

42
increases over the time you hold it, you will experience a capital gain at the time you
sell your share of stock. But, in the event the company does not meet its financial
objectives, there may be no dividends paid, and the value of your share of stock may
stay the same, or even decrease. There is no guarantee that there will be a return
on your investment. As a shareholder, you will have the right to vote on company
decisions.

Why Should I Consider Investing In Stocks?

Most investors who purchase common stock do so based on their potential for
relatively high returns, but there are other factors to consider.

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

Are There Different Kinds of Stocks?

Stocks may be categorized in many ways. Classification by type is probably the most
common method of categorizing.

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

o Growth Stocks – These are stocks which experience high rates of

growth in operations and earnings.

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

o Speculative Stocks – These are stocks of companies which may be

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

o Cyclical and Defensive Stocks- Cyclical stocks are those whose

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

43
Another method of categorizing stocks is by "Market Capitalization" or Size. This
uses the stock’s market price multiplied by the number of shares outstanding,
resulting in the placement of the stock within one of three categories by size:

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

o Mid Cap – Stocks with market caps of from $750 million to $3 to $4

billion. (These stocks are generally considered to offer good returns
without significant price volatility.)

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

How is Stock Performance Measured?

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

Historical rate of return cannot predict future return!

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

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

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

o Price-Earnings Ratio ("P/E") – This is the market price of the stock

divided by the current per share earnings of the corporation.

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

o Beta – This indicates the price volatility in relation to the Market as a

whole (usually measured against the Standard and Poors 500) which
has a Beta of 1.0. Low Beta stocks (less than 1.0) are less volatile than
the Market as a whole; and high Betas (over 1.0) are more volatile.
Betas may also be positive or negative. Positives more in the same

44
 direction as the Market; while negatives move in the opposite
direction.

Other Equity Investments

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

What Equity Investments Other Than Common Stocks Should I Consider for
my Investment Portfolio?

Real Estate – Real estate has historically been useful in a portfolio for both income
and capital gains. Home ownership, in itself, is a form of equity investment, as is the
ownership of a second or vacation home, since these properties generally appreciate
in value. Other types of real estate, such as residential and commercial rental
property, can create income streams as well as potential long-term capital gains.
There are numerous additional equity investments; however, the majority are highly
speculative and require specialized knowledge and expertise, and generally should not
be undertaken by an inexperienced investor without appropriate qualified professional
advice and assistance.

Put and Call Options – A "call" is an option allowing the investor to purchase a
certain stock at a set price at any time within a specified period. A "put", on the other
hand is an option allowing the investor to sell a certain stock to someone at a set price
at any time within the specified period. These are usually bought when the investor
wants to speculate on whether a particular stock is going to go up or down. These are
also considered high-risk investments.

Commodity Futures Trading – A futures contract is an agreement to buy or sell a

commodity (wheat, corn, oats, soybeans, copper, silver, lumber, etc.) at a price stated
in the agreement on a specified future date.

3) Mutual Funds Investments

What Are Mutual Funds?
Mutual funds are large professionally managed portfolios that are formed by many
individual investors who collectively pool their resources in order to achieve a high
level of diversification. More investors, by far, invest in mutual funds than in any
other type of investment product. There are two types of mutual funds:

Open-End Investment Companies – In these funds, investors buy and sell shares
from the fund itself. There is no limit to the number of shares a fund can sell, and buy
and sell transactions are carried out at prices based on the current value of all the
securities in the fund’s portfolio. Net Asset Value (NAV) is based on the current
value of all securities held in the fund’s portfolio, and represents the price at which
the investor can sell his/her shares.

45
Closed-End Investment Companies – Closed end companies operate with a fixed
number of shares outstanding and do not regularly issue new shares. These shares are
listed and traded on an organized securities exchange, and trades may be at a discount
or premium.

Why Should I Consider Investing in Mutual Funds?

Through mutual funds, small investors are able to enjoy a much higher degree of
diversification than they would be able to attain though individual stock or bond
purchases on their own. Most mutual fund accounts can be opened with small initial
investments (some as low as $250). In addition, experienced professional managers
select the securities to be purchased and make timing decisions concerning buying
and selling on the most advantageous basis.

In addition, funds are highly marketable, and mutual funds offer numerous services to
meet individual investor needs. Funds are easy to acquire or sell, and there is very
little paperwork or record-keeping required of the investor.

Finally, the return on many funds has exceeded the average return of many other
comparable investments.

How Do I Make Money In a Mutual Fund?

Mutual funds have three potential sources of return:

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

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

2. Capital Gains Distributions – The fund may sell one of its

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

3. Increase in Share Value Above Purchase Price – The share of

the mutual fund itself may increase in value over the purchase
price. This gain is not realized until the share of the fund is
ultimately sold, at which time it will receive capital gains
treatment for tax purposes.

The overall return (gain or loss) of the fund is based on these three sources.

What Types of Investments are Available Through Mutual Funds?

Almost any type of investment is available through mutual funds. A fund’s
investment objective must be disclosed in its prospectus. The most common fund
objectives are:

Growth Funds – The objective is capital appreciation achieved through long term
growth and capital gains.

46
Balanced Funds – These funds hold a balanced portfolio of both stocks and bonds, in
order to generate a well-balanced return of current income and long term capital
gains.

Money Market Funds – These funds include a portfolio of short-term money market
instruments and have high liquidity, but limited investment return.
Sector Funds – These funds concentrate in one ore more specific industries that make
up the targeted sector such as technology, health, energy, etc.

What Services Are Offered By Mutual Funds?

Numerous services are offered by mutual funds to include:

1) Automatic Investment Plans – Investors may direct specific amounts of money

from paychecks or bank accounts into the mutual fund on a regular basis (usually
monthly).

2) Automatic Re-Investment Plans – Dividends and other distributions are

automatically used to buy additional shares in the fund.

3) Regular Income – For shareholders wishing to receive monthly income, a pre-

determined amount can be withdrawn on a regular basis, with a check mailed to the
investor. This may be a fixed amount or tied to interest and dividend earnings.

4) Conversion Privileges – Investors investing in a "family" of funds may switch

from one fund to another, if their investment objective should change or if they feel
the change would enhance their investment performance. These switches are usually
made without additional sales charge. (This switch would, however, trigger capital
gains taxation, if applicable.)

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 RETIREMENT PLANNING

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

The biggest pitfalls to sound retirement planning are generally considered to be:

 Starting too late (PROCRASTINATION)

 Failing to commit sufficient resources to this goal

 Investing too conservatively

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

Setting Retirement Goals - Where Am I Going?

First, you must ask yourself, "What will my financial needs be during
retirement?" Some financial planners use as a target rule-of-thumb of 70% - 75% of
pre-retirement income. This, of course, assumes that your financial needs will
decrease in retirement. And, sometimes this is true. Expenses may be lower for
example, for those who plan to pay off their existing mortgage and/or other debt
obligations prior to retirement. Also, it is assumed that at retirement, costs relating to
dependent children are gone.

These assumptions may or may not be applicable to your situation. Some planning
candidates actually want to increase their income at retirement, so that they will have
funds for travel, hobbies, etc. A review of your current budget, keeping in mind what
changes (up or down) you think may be applicable to your situation, should give you
a good idea of your financial needs (in today’s dollars).

When Am I Going To Get There?

The next question should be, "When do I plan to retire?" Your answer may be at age
59 ½ (the earliest normal date that qualified retirement funds, IRAs, etc. can be
withdrawn without penalty); or it may be at age 65 (frequently considered the
"standard" retirement age); or something earlier or later. One important point to keep
in mind, the earlier you plan to retire, the more ambitious your accumulation program
must be now!

48
Where Am I Now?
Once you have determined your financial needs in today’s dollars and your target
retirement date, you are ready to calculate the amount of "future" dollars you will
need to accumulate in order to retire.

The first step is to determine what available sources you have at present to contribute
to the funding of this goal. These resources may be in form of a future income stream
(Social Security or a pension benefit from your employer) or in the form of
accumulations such as savings accounts or other personal investments. These amounts
are also converted to "future values" and applied against your needs. The remaining
balance or shortfall is the amount you will need to save between now and your desired
retirement date.

How Am I Going To Get There?

You may be having a difficult time trying to grasp the concept of future dollars. You
are not alone. Many people have a difficult time understanding future impact; both in
terms of how inflation will affect your future needs; and how the compounding of
interest over long periods of time can help you to accomplish a financial goal.

Inflation is the rate at which the general level of prices of goods and services is
increasing. Even projecting a meager level of 3% per year, if you are planning on
retiring in 20 years; and you have estimated your needs in today’s dollars at
Rs.50,000, this means that by retirement, that inflation-adjusted need will be
Rs.90,000! Taking this a step further, twenty years into your retirement that Rs.90,000
will have become Rs.160,000! This inflation factor must be taken into account in all
or your planning efforts or you will find your resources seriously lacking.

On your side, however, is the power of the compounding of interest. To give you a
rule of thumb, which does not require a complicated financial calculation, the Rule of
72 can provide a quick way to estimate the future value of your present assets. This
method tells you how long it will take for a sum to double in value at various
compound rates. You simply divide the number "72" by the applicable interest rate
(rounded to the nearest whole number). The result is the number of years it will take
your original sum to double.

Example

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

49
Can I Get There From Here?
Sadly, many planning candidates -- upon consideration of the amount of savings
necessary to provide their retirement goal -- discover that "they can’t get there from
here." If the savings and/or investment return goal is beyond your reasonable
capabilities, several options exist.

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

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

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

 You may re-assess and re-allocate your current retirement investments in

order to increase the return available to you, while could improve your
ultimate funding balance.

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

What Are The Most Common Roadblocks to a Successful Retirement?

Some of the most common roadblocks to financial success are:

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

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

 Unexpected expenses, such as medical; major home repairs; etc. (Some of

these issues can be dealt with through appropriate Risk Management
strategies; others cannot.)

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

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

 Repeated changes of employment (These changes can prevent you from

becoming vested; that is, having the right to complete access to your benefits
if you should leave your employment.)

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  PROCRASTINATION Always having a "good reason" not to begin your
savings plan ("I’m afraid of the stock market right now"; "I can’t afford to
start participating in the retirement plan until I get my credit cards paid off",
etc.)

What Are My Potential Sources of Retirement Income?

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

Pension Plans and Retirement Programs

In recent years, employer-sponsored plans (especially those that are totally funded by
the employer) have diminished, partly due to the rapidly rising cost of employee
benefits and partly due to the ever-increasing and changing reporting and plan
requirements imposed by the federal government.

If your employer is currently sponsoring a retirement plan, it is important to be aware

of what your benefits will be, and how they are structured. Again, this information
will be needed to accurately complete your Retirement Planning Calculations (above).
There are two basic types of Qualified Retirement Plans, which may be offered by
your employer.

 Defined Benefit

 Defined Contribution

A Defined Benefit Plan specifies the amount of benefit which you will receive at
retirement It may be stated as a specific dollar amount (i.e. Rs.700 monthly,
beginning at age 65); or it may be stated as a percentage or number of units based on
your length of service, salary, and other criteria (i.e. 50% of your average monthly
salary during the last three years of employment). If you are a participant in this type
of plan, it makes your retirement calculations easier, since you know with some
certainty what benefit you will be receiving from your plan.

A Defined Contribution Plan specifies the amount of contribution that will be made
over the accumulation period. But the amount of benefit that will be available is
unknown, since it will be affected by time, the investment return and the amount of
future contributions. For example, an employer’s plan may specify that it will
contribute 3% of your annual salary each year to the plan on your behalf. But the
amount available to you at your retirement will be based on when you retire, how well
the plan’s investments have done over the years, and your actual earnings history
which establish the 3% contribution.

Both of these plans are considered "Qualified Plans" under Federal Tax Laws. As
such they provide several benefits to encourage participation. The first is that any
contributions made to the plan are considered tax-deductible to your employer, and
not considered taxable income for you... The second, and most important, is that all

51
of the growth within this Qualified Plan will be tax-deferred until such time as you
withdraw the money for retirement use. Of course at that time, all withdrawals (both
principal and interest) will be fully taxed as ordinary income.

Generally, both of these Qualified Plans are completely funded by your employer.
However, the trend in recent years has been to replace or supplement these traditional
types of pension plans with plans in which the employees share in the cost.

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

Annuities
There are numerous ways to save for retirement.One commonly used vehicle is the
Deferred Annuity.

An annuity is an investment contract issued by a life insurance company in which an

investor invests a sum of money in the annuity contract, with the sum plus investment
earnings to be returned to the investor at a later time as a lump sum or as a guaranteed
income stream. During the deferred or accumulation phase, funds deposited in this
annuity grow on a tax-deferred basis, just like in the Qualified Retirement Plans.
Annuities may be:

 Single Premium or by installment payment (usually monthly)

 Fixed or Variable in investment nature (fixed guaranteeing the return of

principal and a flat rate minimum rate of interest; with variable, like variable
life, offering the investor the opportunity to select investments from among a
number of investment options.)

An annuity is like other tax-qualified savings vehicles, in that there is a 10% penalty
if funds are withdrawn prior to age 59 ½. When you are ready to begin the withdrawal
phase of an annuity, you will have several choices. These options parallel those that
are usually available in the withdrawal phase of your employer’s Qualified Plan.

Selecting A Retirement Income / Annuity Pay-Out

Most Qualified Retirement Plans offer a number of pay-out options upon retirement.
One option may be a lump sum, representing your entire retirement account balance.
When this option is selected, income taxes will be due in the year of receipt on the
entire amount. Some retirees find this option attractive, if they are going to be in a
very low tax bracket for that year, and their personal retirement goals require a large
lump sum of available cash.

In addition to the lump sum or rollover option, most plans offer one or more
structured pay-outs, which offer income streams for life or for specific periods of

52
time. It is very important to understand these options since the option you select may
greatly affect your cash flow in retirement. And, in almost all cases, once you have
selected and have begun to receive a payout under one of these options, you will not
be allowed to change your option. Some of the most commonly offered payout
streams are as follows:

 Straight Life Annuity Payment – payment stream is guaranteed over the

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

Example

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

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

Example

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

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  Refund Annuity – This annuity guarantees payment for lifetime of the
annuitant, and beyond that, guarantees payment until an amount at least as
large as the purchase payment is reached. In essence, this creates a full
"refund" of premium.

Example

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

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

Example

In this case, if Mrs. Brown had a husband (age 65) and had selected the Joint and
100% Survivor option, her payout would have been Rs. 3000 . This amount
would have been paid for as long as either Mrs. or Mr. Brown was living.

As you can see, there is a difference between the payment levels of these various
options. The more contingencies an insurance company is asked to accommodate the
lower the income flow. For example, the simplest form of payout is the straight life
annuity. The only contingency here is how long one person (the annuitant) will live.
This option provides the highest payout of any life-contingent option. With the
addition of an additional annuitant; a time period that is guaranteed; or especially if
the company has to guarantee a full refund, the payment flows shrink accordingly.
The ten year only option offered a higher payout, however, there would have been no
benefits beyond the ten year period; and at age 65, Mrs. Brown (under normal
circumstances) would have had a life expectancy considerably beyond this 10 year
period.

If you will be selecting a retirement payout from among these options, your own
personal circumstances will dictate which choice is best for you. But there is
sometimes a way to "have your cake and eat it, too".

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How Are Distributions from Retirement Savings Taxed?
The tax treatment depends on how the distribution is paid; that is, as a lump sum
distribution, an "annuitized" (structured and guaranteed) monthly payment; or as
flexible withdrawals. Lump sum distributions are non taxable. Periodic payments
received from an Employer’s Pension or Retirement Plan is also considered ordinary
income, as they are received. But annuity payments will be treated as part principal
and part interest, with only the interest portion being taxable.

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 CONCLUSION

Apart from improving the overall financial health, this can help you take smarter
financial decisions in the long term.
Review your investment portfolio:
Reviewing one's investment portfolio by the end of the year is one of the best steps
for taking a good investment related resolution. While reviewing the overall
investment portfolio, one must ask some basic questions as to how risky the
investment portfolio is and explore the adjustments where required. If you are single
and have started working only recently, you can afford a riskier portfolio compared to
married people with families. One thing that is common while evaluating your
personal investment portfolio for the year is to always maintain a balance between
long-term goals and any emergency requirements for a rainy day.

Pay off debt:

Paying off old debt is one of the best ways to usher in the New Year. Budgeting and
paying off old debt might not be as difficult as it may appear and only require a
principled approach. One can set up accounts to automatically deduct monthly
expenses. Get out of the old debt trap to increase the chances of improving your
financial health in the coming year. The best approach is to start by paying off the
debt with higher interest rates like credit cards and personal loans. If you have some
surplus cash, you may also consider paying off loans as pre payment instead of paying
EMIs.

Invest in an emergency fund:

In this day and age of increasing inflation, sudden job loss or a sudden illness of any
family members can damage your finances. Therefore, it is imperative to consider
investing in an emergency fund. Most financial experts are of the view that such
emergency funds which are also known as contingency funds, must hold finances that
can sustain the dependant members of the family for a minimum period of six months.
If you have not given due thought to have an active emergency fund, make plans to
start it this New Year. Make regular investments in your emergency fund which can
gradually help you a build a corpus that is liquid with the ability to earn handsome
returns.

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Protect your family's financial future:
Protecting your family's financial future is an essential step that needs to be a part of
each financial resolution. A lot of people explore life insurance but totally ignore
medical insurance for dependants and immediate family members. If you are one of
those who have neglected medical insurance of your dependants, plan for a good
package.
For people seeking life insurance as an investment, one needs to understand that life
insurance helps your dependants in case you are not around. Considering insurance
purely as an investment vehicle is a bad financial decision that must be changed.

Improve credit scores:

Another great New Year resolution is to improve your overall credit score (CIBIL).
Many people are stuck with bad credit score due to their own financial
mismanagement. Take a call this New Year to cut out on unwanted credit cards and
loans so that you do not end up spoiling your credit score in the coming year. If you
are planning to avail some loans in the coming months, make sure that you keep a
minimum gap of six months between the two loan applications. Pay your loans and
credit cards on time, avoiding late payments.

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