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February 21, 2007

How Much Do You Need for Retirement

One of the most critical factors in determining how much you need to accumulate by retirement age is how much annual income you’ll need in retirement. But if that retirement date is years or decades away, it may be difficult to come up with a reasonable estimate of your income needs. Most people will want a standard of living in retirement similar to the one they’re living before retirement, so simple rules of thumb, like 70% of preretirement income, may not give you an accurate estimate. Follow these tips to estimate how much you’ll need:

Add up your current expenses. Make sure the list is as complete as possible, including regular monthly expenses as well as irregular, periodic expenses, such as insurance premiums, tuition, and gifts. If you’ve prepared a detailed budget, much of the work will already be done. If you don’t have a budget, most of the information can be found by examining cancelled checks, credit card bills, and tax returns. If you can’t account for more than 5% of your income, you may need to take a closer look at your cash purchases.

Estimate which expenses won’t be incurred in retirement. Once you retire, you won’t need to save for retirement anymore. Other expenses that are likely to go away include commuting costs, some clothing expenditures, and meals while working.

Determine what additional expenses to expect after retirement. This will depend in large part on how you plan to spend your retirement years and will typically include items like travel and entertainment. At this point, you want to plan for your ideal retirement lifestyle. Don’t forget to consider health care costs. Even if you qualify for Medicare, most people incur substantial out-of-pocket costs.

Decide what expenses you can cut back on. This analysis will become critical if you can’t afford your ideal retirement. Break down your expenses between essential and discretionary. Essentials will include food, utilities, health care, transportation, and housing. Discretionary could include travel, entertainment, and purchases of luxury items. Cutting back on discretionary items is not your only alternative. Perhaps you can move to a smaller home or pay off your mortgage, both of which could dramatically lower your expenses. Or, you might only need one car instead of two after retirement.

Once you decide how much retirement income you need, you can calculate how large a nest egg you’ll need at retirement. Be as accurate as possible, since overlooking just one or two items can significantly change the income you’ll need.

February 13, 2007

Becoming Debt Free

Increasing debt levels can make it difficult to achieve your financial goals. If a significant portion of your income is going toward debt payments, that leaves less available to put aside for your financial goals. While it may be difficult to achieve debt-free status when you own a home with a mortgage, it is a reasonable goal to owe no debts other than your mortgage. To help you with that goal, consider the following steps:

1. Stop incurring new debt. If you are truly committed to reducing debt, stop incurring additional debt. Only use credit cards if you can pay the balance in full every month. Instead, use a debit card, which automatically deducts charges from your bank account. If you don’t have cash for a purchase, wait until you can save the money.

2. Investigate consolidating debts with a lower interest rate option. You may be able to transfer credit card and other debt balances to lower interest rate alternatives. However, don’t use this strategy until you have step 1 under control. You don’t want to obtain a lower interest rate card and then just start adding new balances to it.

You may also want to consider using a home-equity loan to pay off your consumer debts. Home-equity loans typically carry lower interest rates than other forms of personal loans, and as long as the balance does not exceed $100,000, interest paid on home-equity loans is deductible on your tax return as an itemized deduction. Keep in mind that you are taking equity out of your home. This may be a good tradeoff if you use the funds to reduce higher cost debt. However, if you just run those balances up again, you still have the consumer debt plus less equity in your home. To compare Home Equity Rates from both state specific and national lenders go to the ManagingMoney.com Mortgage Center.

3. Prioritize and pay down your debts. List all your debts and monthly payments, listing the debts from highest to lowest interest rates. Add up your minimum payments and then determine how much more you can budget to pay down those debts. Rather than paying a little bit extra on all your debts or adding extra to your mortgage payment, use these additional funds to pay off the debt with the highest nondeductible interest rate. Once that debt is paid in full, start paying the debt with the next highest interest rate, continuing until all your debt is paid in full.

February 9, 2007

What Are Irrevocable Life Insurance Trusts

Typically, irrevocable life insurance trusts (ILITs) have been used to help pay estate taxes through the use of life insurance proceeds not considered part of the deceased’s estate. The trust receives the life insurance proceeds free of estate and income taxes. But with the uncertain future of estate taxes, you may wonder whether ILITs are still a valid estate planning strategy. You probably don’t want to undo any ILITs in place, since the estate tax won’t be fully repealed until 2010 and then will be reinstated in 2011. Even if the proceeds aren’t needed for estate tax purposes, you may find other uses for the proceeds, such as leaving larger bequests to beneficiaries or charitable organizations. Deciding whether to set up a new ILIT is a tougher decision. You should first analyze all relevant factors, including your views about the future of the estate tax. Below are some of the basic factors of irrevocable life insurance trusts (ILITs) that may help you with this analysis.

With an ILIT, you set up a trust to own an existing or new life insurance policy. Annually, you can make gifts to the trust to pay the policy premium, with a properly structured gift subject to the annual gift tax exclusion ($12,000 per beneficiary in 2006, $24,000 per beneficiary if the gift is split with your spouse). After your death, the trust receives the insurance proceeds, which are distributed according to the trust’s terms. For the proceeds to be excluded from your taxable estate, several conditions must be met:

• The trust must be irrevocable. Once the trust is set up, you can’t change its provisions or control the assets. In legal terminology, you can’t retain any incidents of ownership, which include the power to change the beneficiary, to surrender or cancel the policy, to assign the policy, to remove an assignment, to pledge the policy for a loan, and to obtain a policy loan. You can stop funding premiums, but you cannot recover any sums already paid to the trust.

• Gifts to the trust must represent a present interest to qualify for the annual gift tax exclusion. Typically, beneficiaries won’t receive benefits from the insurance policy until sometime in the future. To change this future interest to a present one, the beneficiaries must have the ability to withdraw the money now. The trustee will normally send a written notice to all beneficiaries when the cash is received, giving them a short period, perhaps 30 days, to demand the assets. Once that period passes, the trustee can use the funds to pay the insurance premium.

• The trustee can’t be specifically instructed to pay the insured’s estate tax liabilities. If that is done, the proceeds are considered received for the estate’s benefit and will be subject to estate taxes. However, the trustee can have the power to loan money to the estate or to purchase assets from the estate to provide liquidity for paying estate taxes.

• A transferred life insurance policy must be in the trust for three years before your death or the proceeds will be included in your taxable estate.

If you are concerned about the irrevocable nature of the ILIT, you can give broad powers to the trustee, so he/she can do things like change the policy type, withdraw or borrow from the policy, surrender the policy, or distribute assets while you are alive.

In light of the uncertain future of the estate tax, you should carefully assess the advantages and disadvantages before setting up an ILIT.

February 7, 2007

Using Average Returns in an Investment Program

When setting up an investment program, the assumed rate of return is typically an average annual return for some historical period. While that is generally viewed as a conservative approach, there are some problems with using an average return:

• Average returns are an average of past returns and do not indicate what will happen in the future. Economic and market events may or may not replicate past events.

• The average annual return can vary substantially, depending on the historical period used. For instance, from 1926 to 2005, the Standard & Poor’s 500 (S&P 500) had an average annual return of 10.4%. From 1986 to 2006 (20 years), the average return was 11.9% and 9.1% from 1996 to 2005 (10 years).* Those differences in average returns would project a substantially different portfolio value over an extended time.

• The average return does not reveal the pattern of returns over that period. Some years will experience higher returns, while other years will experience lower or even negative returns. Even if you select an average return that is exactly right, your portfolio’s ultimate balance will depend on the pattern of returns over that period. For instance, if you experience high returns in the early years when your portfolio’s balance is low and then lower returns in the later years when your portfolio’s balance is higher, you will have a lower value than if the opposite occurred.

• Most people don’t just allow a lump sum to grow, but make deposits and withdrawals over the years. Since your actual return fluctuates from year to year, your pattern of additions and withdrawals can also significantly impact your portfolio’s ultimate value.

While it is instructive to consider average returns when developing an investment program, you can’t simply project that return into the future. Instead, consider these steps when deciding on an estimated rate of return:

Evaluate your expectations for future returns against historical averages. It may be prudent to assume lower returns in the future. It is easier to save less if you obtain higher returns than to try to save more over a short time period if your actual return is lower.

Consider a range of possible returns for your portfolio. What would happen to your portfolio’s balance if you earned your expected return, 1% less, 2% less, etc.? This analysis can help you determine what adjustments would need to be made to compensate for lower returns.

Review your progress every year. This will allow you to make adjustments along the way. If your return is lower than expected, you may need to increase savings or change investment allocations.

* Source: Stocks, Bonds, Bills, and Inflation 2006 Yearbook, Ibbotson Associates. The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market. Investors cannot invest directly in an index. Past performance is not a guarantee of future results. Returns are presented for illustrative purposes only and are not intended to project the performance of a specific investment.

February 5, 2007

Implications of Investment Theory

Many investment principles used to develop investment portfolios derive from one investment theory: the capital asset pricing model. What exactly is the capital asset pricing model, and how does it apply to your particular investments?

The capital asset pricing model was developed over 50 years ago by Harry Markowitz, who won a Nobel Prize for his work. His theory centers on the concept that adding an asset to a portfolio that is not highly correlated with other assets in the portfolio can reduce the portfolio’s variation risk. Before his theory, it was common practice to look for undervalued assets to add to a portfolio. His approach evaluated how a particular asset would impact the portfolio’s risk and return. Whether it makes sense to add that investment to the portfolio depends as much on how the asset’s return will vary with returns of other portfolio assets as on its own return prospects.

This theory provides the underlying rationale for asset allocation. The key is that the returns of different assets do not behave in the same manner during different economic times, so adding different assets can reduce the volatility in that portfolio. While the return of a diversified portfolio may be lower than that of investing solely in the best performing asset, that is typically viewed as an acceptable tradeoff for the reduced risk. Many people have also realized that it is difficult to identify the best performing asset in any given year, so a diversified portfolio provides more consistent returns.

Some of the investment implications that have been drawn from the capital asset pricing model theory include:

• A properly diversified portfolio will combine assets that do not have highly correlated returns. Thus, when one asset is declining, other portfolio assets may be increasing or not decreasing as much.

• Rather than focusing on each investment’s risk, investors should consider their portfolio’s overall risk.

• Including a small percentage of a volatile investment may not increase a portfolio’s overall risk, provided that investment’s returns do not vary closely with other assets’ returns in the portfolio.

• When small portions of stocks are added to an all bond portfolio, risk initially decreases, even though stocks are more volatile than bonds. Thus, an all bond portfolio is not the lowest risk portfolio.

• Investors should consider how varying percentages of different asset classes will affect their portfolio’s risk and return before deciding on an asset allocation.

Managing Your Portfolio

Consider this investment process to incorporate the capital asset pricing model theory:

Determine your risk/return preferences. You should assess the potential downside as well as upside for various investments to get a feel for how much risk you can tolerate.

Decide on an asset allocation mix. Your asset allocation strategy represents your personal decisions about how much of your portfolio should be allocated to various investment categories. After considering your risk tolerance, time horizon for investing, and return needs, you can form a target asset allocation mix. Within broad investment categories, make allocation decisions for each category. Not only will each individual’s allocation strategy differ, but your strategy will vary over time.

Select individual investments. Investigate a wide range of options, but make sure you understand the basics of each, examining the types of risk they are subject to as well as their historical rates of returns. Your selections should fit in with your overall asset allocation.

Rebalance periodically. Over time, your asset allocation will stray from your desired allocation, due to varying rates of return on your investments. Determine how much variation you are willing to tolerate, perhaps 5% or 10% from your desired allocation. If portions of your portfolio have strayed more than that, you should take steps to get your allocation in line. However, first determine if there are ways to do so without incurring tax liabilities. Selling assets from taxable accounts may result in taxable transactions. Instead, you may want to make new investments in underweighted assets, redirect periodic income to other asset classes, or take withdrawals from overweighted assets.


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