General Principles of Financial Planning 15% Flashcards
Monetary Policy (Federal Reserve)
3 methods for controlling money supply
Discount Rate
Open Markets Operations
Reserve Requirements
Monetary Policy:
The Federal Reserve Bank (Fed) controls the money supply, enabling it to significantly affect interest rates.
Expansion (ease) or Restrictive (tighten)
- Discount Rate: “Banks borrow $ from Fed”
This is the rate at which member banks can borrow funds from the Federal Reserve to meet reserve requirement - Open Market Operations: “Feds Buying Govt Bonds from Public”
This is the process that the Federal Reserve follows to purchase and sell government securities in the open market
*Buy-Ease-Sell-Tight - Reserve Requirements: “$ % each bank must hold”
The reserve requirement for a member banks of the Federal Reserve Bank is the percentage of deposit liabilities that must be held in reserve.
Fiscal Policy (Government)
Spending
Taxation
Debt Management
Spending
Taxation
Debt Management
- Expansionary (easy) fiscal policy—when the government increases purchases of goods and services while holding its revenues constant, it creates a budget deficit and stimulates aggregate demand
- Restrictive (tight) fiscal policy—when the government either reduces its expenditures of goods and services or raises taxes, it causes a budget surplus or a reduction in the budget deficit
Real Rate of Return
*The price of borrowing $ is the interest rate
*The nominal interest rate measures the yield in dollars per year per dollar invested
RoR = (1 + nominal rate / 1 + inflation rate -1) x 100
Demand Curve
(Economic Concepts)
a. The amount of a commodity people buy depends on its price
b. The relationship between price and quantity bought is called the demand curve
Price (Y axis) Quantity (X axis)
- Downward sloping demand—if the price of a commodity is raised, buyers tend to buy less of that commodity
- When the price is lowered, quantity demanded increases
The law of demand states that the quantity purchased varies inversely with price. In other words, the higher the price, the lower the quantity demanded.
Supply Curve
(Economic Concepts)
a. The quantity of a good that businesses willingly produce and sell
b. The supply curve for a commodity shows the relationship between its market price and the amount of that commodity producers are willing to produce and sell
Price (Y axis) Quantity (X axis)
As the price of a good or service increases ↑, the quantity of that good or service that suppliers offer will increase ↑, and vice versa.
This means that as the price of an item goes up, suppliers will attempt to maximize their profits by increasing the number of that item that they sell.
How Cash Flow Statements are Presented for a Period to a Client
Indicates a period covered (e.g., “January 1, 20XX, to December 31, 20XX”
OR
“For the Year Ending December 31, 20XX”), in contrast to the personal statement of financial position, which provides values as of a given date
Discretionary Expense
“NON essential expense”
A nonessential recurring or nonrecurring expense for an item or service.
a. Fixed discretionary expenses may include the following
1.) Club dues
2.) Premium cable TV fees
3.) Streaming video services
4.) Phone plans
Nondiscretionary Expense
“ESSENTIAL expense”
A nondiscretionary expense is a recurring or nonrecurring expense that is ESSENTIAL for an individual to maintain his life
Fixed nondiscretionary expenses may include the following
1.) Rent or mortgage payments
2.) Auto and health insurance premiums
3.) Loan repayments
Emergency Fund
a. Helps the client withstand a sudden disruption of income or an extraordinary expense
b. Comprised of cash and cash equivalents
c. Should generally be
3 (two working spouses) to
6 (one working spouse) months’ worth of nondiscretionary cash flows to accommodate unemployment, loss of significant assets, or other unexpected major expenditures
Snowball Technique
Debt Management Technique
Smaller balances are paid off first so clients feel encouraged by their success and motivated to continue the process.
Avalanche Technique
Debt Management Technique
Paying off debt with the highest interest rate % 1st and then focusing on debt with the next highest interest rate, until all of your client’s debt is paid off.
Home Mortgages
- Fixed Rate
- Level interest rate for the term of the loan
- Fixed payment amortization schedule
- The shorter the term, the higher the monthly payment, given the same interest rate
Home Mortgages
- Adjustable Rate Mortgage (ARM)
- Interest rate changes, usually in relation to an index, and monthly payments may go up and down accordingly
- Initial rate and payment can change every month, quarter, year, three years, or five years
- Interest-rate caps place a limit on the amount the interest rate can change
Home Mortgages
- FHA (Federal Housing Administration)
*guaranteed by gov’t
*<20% down payment
*PMI required
- Guaranteed by the federal government
- Low down payment, and sometimes lower interest rate due to the federal government’s guarantee of repayment
- Mortgage insurance requirement
a.) Mortgage insurance is a policy that protects lenders against losses that result from defaults on home mortgages
b.) FHA requirements include mortgage insurance primarily for borrowers making a down payment of less than 20%
Home Mortgages
- VA (Veterans Administration)
- For veterans of the U.S. armed services only
- No down payment required
- No mortgage insurance requirement
- Same federal guarantee of repayment as with FHA loans
Home Mortgages
- Interest Only
- Only interest on the mortgage is paid monthly for a specific time (5–10 years)
- Keeps mortgage payment to a minimum, principal balance remains unchanged
- Suitable for homeowners with a SHORT TIME HORIZON for ownership and those with sizable liquid assets
- If housing prices fall, the home may not be worth as much as the mortgage balance
a.) May be difficult to refinance
Home Mortgages
- Reverse Mortgage
*Borrowers must be age 62 or older with a residence that is free from indebtedness
- Technically, a Home Equity Conversion Mortgage (HECM)
- Lender pays homeowner an income stream secured by equity in the home
- Amount of payments based on the fair market value of the home and the age of the borrower
- Homeowner retains title but incurs an increasing amount of debt with each payment received from the lender
- Repayment of the outstanding mortgage is required if the homeowner dies, sells the home, a predetermined loan period comes to an end, or the owner no longer occupies the home (typically for a period of 6–12 months)
Home Mortgages
- HELOC
- Essentially second mortgages using the current equity in the homeowner’s primary residence to provide money for home improvements or other purposes
- Home equity loan: borrower receives a lump sum in the amount of the loan
Education Tax Credits & Deductions
- American Opportunity Tax Credit
($2500)
- Equals 100% of the first $2,000 of qualified expenses paid in the tax year, plus 25% of the next $2,000
- The maximum credit allowed in a given year is $2,500 per student, if there are $4,000 of qualifying expenses
- Requirements
a.) Available for qualified tuition, enrollment fees, related expenses and expenses for textbooks and other course materials incurred and paid in the first four years of postsecondary education for the taxpayer, spouse, or dependent.
*ROOM & BOARD ARE EXCLUDED.
b.) Student must be enrolled no less than half time to be eligible
c.) In 2023, the credit is subject to a phaseout based on the taxpayer’s MAGI
(Married filing jointly: $160,000–$180,000)
(All other taxpayers: $80,000–$90,000)
d.) Up to 40% of the eligible AOTC credit is refundable, so even those who owe no tax can get up to $1,000 of the credit for each eligible student as cash back. For example, if a taxpayer owes no taxes and is eligible to take the maximum AOTC of $2,500, he will receive a tax refund of $1,000 (40% of $2,500).
Education Tax Credits & Deductions
- Lifetime Learning Credit
($2K)
Benefits
1. Provides annual taxpayer reimbursement for qualified tuition and related expenses per family in the amount of $2,000 per year BUT the taxpayer must spend $10,000 annually on qualified educational expenses to qualify for the full credit
Requirements
1. This tax credit is available for tuition and enrollment fees for undergraduate, graduate, or professional degree programs
2.) Neither requires enrollment in a degree program nor necessitates at least half-time enrollment
3.) Can be claimed for an unlimited number of years
4.) In 2023, the credit is subject to a phaseout based on the taxpayer’s MAGI (Consolidation Appropriations Act, 2021)
a.) Married filing jointly: $160,000–$180,000
b.) Single: $80,000–$90,000
c.) Married filing separately: not available
Education Tax Credits & Deductions
- Employers Educational Assistance Program
($5250)
- An employer can reimburse an employee’s tuition (both graduate and undergraduate), enrollment fees, books, supplies, and equipment, and these benefits are excluded from the employee’s income up to $5,250 per year
- The employer or employee cannot, however, also claim an education credit (American Opportunity Tax or Lifetime Learning Credit) for the same expenses. If the employee has expenses greater than $5,250, the employee will be permitted to claim an education credit for the expenses over $5,250 (assuming the employee also meets the requirements for the education credits).
Education Tax Credits & Deductions
- Deduction for student loan interest
- Allowed to student (or parent if a PLUS loan) for interest paid on loans incurred solely to pay qualified higher education expenses at eligible educational institutions
- Interest is deductible as an adjustment to reach AGI (an above-the-line deduction)
- Maximum: $2,500 per year
2023 phaseout limits
a.) Single taxpayers: $75,000–$90,000 modified AGI
b.) Married filing jointly: $155,000–$185,000 modified AGI - Borrowers are allowed to deduct interest over the term of their loan obligation
Section 529 Plan (Type 1)
- Prepaid Tuition Plan
*Lock in Today’s Dollars
*Only certain school
- Allow parents to prepay tuition today at a PARTICULAR school for an individual in the future
- The plan will lock in TODAY’S PRICES but subjects the participant to risks
a.) The beneficiary may choose a school different from the one named in the plan
b.) The beneficiary may not be accepted into the school named in the plan
Section 529 Plan (Type 2)
- College Savings Plan
- Allows an individual to make contributions today into a savings fund
- Earnings grow tax-deferred
- If the proceeds are used for higher education expenses, the distributions are received income tax-free
Coverdell Education Savings Accounts
(2K/year per child)
- Benefits
Contributions grow tax free & distributions are tax free if used for qualified educational expenses - Requirements
Child has to be under 18 (unless child has special needs) - Contributions
No contributions after 18 y/o (unless child has special needs)
Phaseout limits for 2023 - Rollover
When beneficiary reaches 30 y/o, the account MUST be distributed to them w/in 30 days. Subject to income tax and 10% penalty.
Account may be rolled over to younger sibling (tax-and penalty-free).
If the new beneficiary is a generation below the generation of the original beneficiary, the distribution is treated as a taxable gift.
Savings Bonds
Series EE/I
Buy AFTER 89’ for education tax treatment
- Under normal circumstances, the accumulated interest on Series EE bonds that are redeemed is taxable income.
However, if the bonds are redeemed during a year in which the taxpayer or taxpayer’s family member has qualified higher education expenses, this interest avoids taxation (within limits). - Face values start as low as $25 and increase up to $10,000
- Purchased electronically at full face value and have varying interest rates
- They must be purchased after 1989 to be eligible for special tax treatment
- Owners must redeem the bonds in the same year that the student/child’s qualified higher education expenses are paid
- The exclusion is subject to a phaseout in the years in which the bonds are redeemed and the tuition is paid.
The modified adjusted gross income phaseouts for 2023 are
$137,800–$167,800 for joint returns
$91,850–$106,850 for single returns.
Married taxpayers filing separately do not qualify for the exclusion.
UGMA/UTMA
- Allows parents to put assets in a custodial account for a child
- If child is younger than 19 or 24 if full time student, a portion of the child’s unearned income may be taxed at the parents income tax rates
- When child reaches age of majority (18 or 21), they may have full access to the funds & not required to use for college education.
- The child is considered the OWNER of the assets w/in the account.
Peak Business Cycle
The point at the end of the expansion phase when most businesses are operating at capacity and gross domestic product (GDP) is increasing rapidly.
The peak is the point at which GDP is at its highest point and exceeds the long-run average GDP.
Usually, employment peaks at this point.
Trough Business Cycle
End of the contraction phase where businesses are operating at their lowest capacity levels.
Unemployment is rapidly increasing and peaks because sales fall rapidly.
GDP growth is at its lowest or negative.
Contraction Business Cycle
Leads —> to trough.
Business sales fall.
Unemployment increases.
GDP growth falls.
Expansion Business Cycle
*(Also called recovery phase)
Leads to peak.
Business sales rise. GDP grows.
Unemployment declines.
Recession Business Cycle
Occurs when the GDP has experienced a decrease in real terms for 2 consecutive quarters or a minimum of 6 months from a baseline of zero,
Characterized by the following:
1.) Consumer purchases decline
2.) Business inventories expand
3.) GDP falls
4.) Capital investment falls
5.) Demand for labor falls
6.) Unemployment is high
7.) Commodity prices fall
8.) Business profits fall
9.) Interest rates fall as a result of reduced demand for money
Depression Business Cycle
Persistent recession and a severe decline in economic activity
Illusion of Control
(Cognitive Biases)
You believe you can control the outcome of an event when you cannot
Money Illusion
(Cognitive Biases)
You have a tendency to think $1 has the same value today, tomorrow, and into the future without considering inflation.
Conservatism
(Cognitive Biases)
You initially form a rational view but fail to change that view as new information becomes available
Hindsight Bias
(Cognitive Biases)
you have a selective memory of the past and have a tendency to remember your correct views and forget your errors
Confirmation Bias
(Cognitive Biases)
You look for ways to justify your current beliefs
Representativeness
(Cognitive Biases)
When considering your choices in a decision you tend to recall a past experience similar to the present decision making the situation and assume one is like the other
Mental Accounting
(Cognitive Biases)
You tend to place money into separate mental “accounts” based on the purpose of these accounts
*debt reduction
*vacation fund
*savings account
Cognitive Dissonance
(Cognitive Biases)
You have conflicting attitudes beliefs or behaviors that cause a feeling of mental discomfort. To changing some of your attitudes beliefs or behaviors to reduce your discomfort and feel more balanced
Self Attribution Bias
(Cognitive Biases)
Taking credit for your successes and blaming others or internal influences for your failures
Anchoring Bias
(Cognitive Biases)
You make a irrational decision based on information that should have no influence on the decisions
Outcome Bias
(Cognitive Biases)
You tend to take course of action based on the outcomes of PRIOR events, ignoring current situations
Framing Bias
(Cognitive Biases)
Asserts that people are given a frame of reference, a set of beliefs or values, which they use to interpret facts or conditions as they make decisions
Recency Bias
(Cognitive Biases)
You give recent information more importance because you remember it most distinctly
Herding
(Cognitive Biases)
When investors trade in the same direction or in the same securities and, possibly, trade contrary to the information they have available.
Prospect Theory
(Emotional Biases)
Clients fearing losses much more than valuing gains. Accordingly, they will often choose the smaller of two potential gains if it avoids a sure loss.
Loss Aversion
(Emotional Biases)
You fear losses much more than you value gains and you prefer avoiding losses to acquire the same amount and gains
Overconfidence
(Emotional Biases)
You believe that you can control random events merely by acquiring more knowledge and consider your abilities to be much better than they are
Self Control Bias
(Emotional Biases)
You lack self discipline & favor immediate gratification over long term goals
Status Quo Bias
(Emotional Biases)
*unwillingness to make changes even if they are beneficial to you
You are comfortable with an existing situation which leads to an unwillingness to make changes even though the changes are beneficial
Endowment Bias
(Emotional Biases)
You think an asset you own is worth more than it is because it’s yours
Regret Aversion Bias
(Emotional Biases)
Attach undue weight to actions of commission (doing something) and do not consider actions of omission (doing nothing).
You do nothing out of excess fear that your decisions or actions could be wrong
Affinity Bias
(Emotional Biases)
You make decisions based on how you believe the outcomes will represent your interests and values
Paul and Tiffany have three dependent children studying at Matheson University. Luke is a senior, Chloe is a junior, and Tom is a freshman. Paul and Tiffany are filing their taxes and want to use the American Opportunity Tax Credit and Lifetime Learning Credit to their greatest advantage. Assuming they qualify for both credits, which of these statements is CORRECT?
A)They can use one American Opportunity Tax Credit for the qualified education expenses of Tom and Chloe and use one Lifetime Learning Credit for Luke.
B)They can use the American Opportunity Tax Credit for qualified education expenses for Tom and use two Lifetime Learning Credits for Luke and Chloe.
C)They can only take one credit for each child—whichever credit will give them the greatest advantage.
D)They can use the American Opportunity Tax Credit for the qualified education expenses of Chloe and use two Lifetime Learning Credits for Luke and Tom.
C) They can only take one credit for each child—whichever credit will give them the greatest advantage.
The answer is they can only take one credit for each child—whichever credit will give them the greatest advantage.
The American Opportunity Tax Credit can be used for qualified education expenses for only the first four years of postsecondary education for each student (a per-student credit).
The Lifetime Learning Credit is allowed once per year per family (a per-tax return credit).
However, the same expenses may not be used to qualify for both credits.
Therefore, an American Opportunity Credit is available for each of the three children.
What is the most likely cause of an increase in the money supply?
A) Bank reserves have increased.
B) The Fed has bought securities.
C) Bank lending has decreased.
D) Consumer demand has increased.
B) The Fed has bought securities.
The most likely cause of an increase in the money supply is that the Fed has bought securities, thus injecting money into the banking system.
Dave and Linda Miller have asked you for advice on financing their son’s college education. Although their son is already 15 years old, they have failed to save sufficient money to finance his education. Their income exceeds $175,000 per year, but they spend as much as they earn. If the Millers need to obtain education funds, which of the following would you recommend?
A) Pell Grant
B )Subsidized Stafford loan
C) Federal work-study program
D) Parent Loan for Undergraduate Students (PLUS loan)
D) Parent Loan for Undergraduate Students (PLUS loan)
Because of the Millers’ income level, their only alternative from the choices offered is a PLUS Loan. Subsidized Stafford loans, Pell Grants, and the federal work-study programs are all need-based.
Charles and Kristy have a one-year old daughter, Isabella. One of their goals is to begin saving today for Isabella’s high school education at Greenleaves Academy. After analyzing Charles and Kristy’s financial statements and other relevant information, you conclude that they should save $2,000 at the beginning of each year for the next 13 years. Which of these education planning vehicles is most appropriate for Charles and Kristy?
A) UTMA
B) Series EE savings bonds
C) Traditional IRA
D) Coverdell Education Savings Account (CESA)
D) Coverdell Education Savings Account (CESA)
Funds saved in a Traditional IRA and Series EE savings bonds may NOT be used for high school expenses.
Due to the lack of education-related benefits and minimal tax-related benefits of an UTMA, a CESA provides a better savings option.
Which is the CORRECT description of the relationship between income, assets, and financial aid?
A higher percentage of assets and income included increases the expected family contribution (EFC) and reduces the available financial aid.
Total cost of attendance ‒ EFC = available financial aid.
Given the following data for Daphne Jones:
Checking account $1,000
Jewelry $5,000
Mutual funds $60,000
Vested Section 401(k) $55,000
Mortgage balance $95,000 (L)
Auto loan balance $20,000 (L)
Money market account $10,000
Personal assets $50,000
Sailboat $7,000
Credit card balance $5,000 (L)
Stock portfolio $10,000
90-day CD $2,000
Automobile $35,000
Personal residence $150,000
What is her net worth?
$265,000
Total assets $385,000
Total liabilities (− $120,000)
(mortgage balance + auto loan balance + credit card balance) =
Net worth $265,000
consumer debt ratio?
Monthly consumer debt ÷ monthly net income
*< 20% of net monthly income
should not exceed 20% of NET monthly income.
You have gathered the following information from Gerry’s financial statements:
Gross income: $110,000
Net income: $80,000
Total assets: $195,000
Total debt: $30,000
Consumer debt: $18,000
Based on this information, which of the following statements is CORRECT?
I. Gerry’s total debt ratio exceeds the generally recommended maximum.
II. Gerry’s consumer debt ratio exceeds the generally recommended maximum.
II only
TOTAL DEBTS do not exceed 36% of gross income. Gerry’s total debt ratio is 27%, less than the 36% maximum ($30,000/$110,000 = 27.3%). (Total Debt/Gross Income)
The consumer debt ratio is the ratio of consumer debt payments to net income. Gerry’s consumer debt ratio is 22.5%, which exceeds the generally recommended maximum of 20% ($18,000/$80,000 = 22.5%). (Consumer Debt/Net Income)
Total Debt Ratio
total mos debt / mos gross income
(<36%)
Total Debt / Gross Income
Should not exceed 36% of gross income.
Consumer Debt Ratio
(<20%)
Consumer Debt / Net Income
The consumer debt ratio is the ratio of consumer debt payments to net income. Recommended a maximum of 20%
Clarence has been investing $1,000 at the end of each year for the past 15 years. How much has he accumulated, assuming he has earned a 10.5% rate of return compounded annually on his investment?
Answer: $33,060.04
END mode
PMT: (1,000)
PV: 0
I/YR : 10.5
N: 15
Solve for FV: $33,060.04
Adam, a CFP® professional, has reached the point of implementing Susie’s financial plan. Susie has a limited amount of financial experience and the process took a few extra meetings to mutually define the scope of the engagement and clearly understand her risk tolerance. Which of these statements are CORRECT and should be followed as an instruction for Adam’s implementation process?
I. Adam should identify the activities necessary for the implementation process.
II. Adam should identify the activities that Susie will be responsible for in the future.
III. Adam should have the scope of the engagement in writing to follow as a guide during the implementation process.
IV. Adam should share information as authorized when necessary during the implementation process.
A) I only
B) I, II, and IV
C) II and III
D)I, III, and IV
B) I, II, and IV
The scope of the engagement is NOT required to be in writing. This may be a good idea to help the financial planner stay on track, but CFP Board is satisfied with the scope of the engagement being mutually agreed upon orally or in writing.
Eugene wants to purchase a fishing camp in 5 years for $60,000. What periodic payment should he invest at the beginning of each quarter to attain the goal if he can earn 10.5% annual rate of return, compounded quarterly on investments?
$2,260.09
BEG mode
FV: 60,000
I/YR : 2.625 (10.5 ÷ 4)
N: 20 (5 × 4)
PV: 0
Solve for PMT: $2,260.09
Which of the following statements regarding Stafford Loans is(are) CORRECT?
II. Subsidized Stafford Loan, = the U.S. Department of Education pays the interest while the student is in school and during any deferment period.
III. Unsubsidized Stafford Loan, = the student is responsible for any interest during the life of the loan.
B) 2 and 3
B) 2 and 3
Statement 1 is incorrect; only subsidized Stafford Loans are needs based.
Which of the following statements concerning the time value of money is(are) CORRECT?
I. The opportunity cost of an activity is the value of the lost opportunity to engage in the best alternative activity with the same resource.
II. An opportunity cost is incurred when an individual pays his bills prior to the due date.
I & II Both statements are correct
COLLEG FUNDING
Mike and Mona had a baby boy two months ago. They want to invest a lump sum today that will provide for four years of education when he starts college at the age of 18. State College costs $12,000 annually today, and they believe education inflation will remain constant at 6% and that they can receive a 7% return on their investment. What is the amount they would require?
Step 1 END
Step 2 BGN
Step 3 END
Step 1:
Inflate today’s college tuition to when child starts college:
N:18
I/YR: 6
PV: (12,000)
Solve for FV: 34,252.0698.
Step 2: BEG Mode
Calculate present value needed at start of school, using inflation-adjusted interest rate:
I/YR: (1.07/ 1.06 -1) x 100 = 0.9433
N: 4
PMT: 34,252.0698
Solve for PV= 135,099.5414.
Step 3
Take lump sum needed at start of college and calculate the present value needed today.
FV: 135,099.5414
N:18
I/YR: 7
Solve for PV: $39,971.
Fritz has asked his financial adviser how much he would accumulate if he were to start adding $5,000 at the end of each year for the next 20 years to his investment account, which is currently worth $22,450. He anticipates earning an average annual return of 6.5% on his investments. What would Fritz’s investment account be worth in 20 years, assuming he earns this annual rate of return?
ANSWER: $273,232
END Mode
1, DOWNSHIFT, P/YR
PV: (22,450)
PMT: (5,000)
N: 20
I/YR: 6.5
Solve for FV = $273,232 rounded.
John deposits $5,000 into an account that will earn 9% interest compounded annually. This sum will grow to what amount at the end of year 7?
ANSWER: $91940
This is a future value of a lump sum calculation.
PV: (5,000)
I/YR: 9
N: 7
Solve for FV= $9,140.20
What is end of the month payment required to accumulate a balance of $150,000 in ten years at an assumed interest rate of 11% compounded monthly and a beginning savings balance of $2,500?
ANSWER: $656.81
PV = (2,500)
I/YR = 0.9167 (11 ÷ 12)
N = 120 (10 × 12);
FV = 150,000;
Solve for PMT = $656.81
Todd and Sharon were thrilled when their daughter was accepted into their beloved alma mater, State University. Now they are wondering how to pay the costs. In which order should they liquidate the following assets:
I. $4,000 from her UTMA account
II. $4,000 from Sharon’s Section 401(k) plan as a hardship withdrawal
III. $4,000 from Sharon’s traditional IRA
IV. $4,000 from Todd’s Roth IRA
I, IV, II, III
Money in the child’s UTMA account is considered an asset of the child and counts the most towards the expected family contribution (EFC) for financial aid purposes. Also, the income tax bill on the UTMA sale will be small. So the low current income tax and the better positioning for financial aid means the UTMA goes first.
The next most tax efficient asset would be Todd’s Roth IRA. The Roth withdrawal will not owe income tax on the basis in the account so less than $4,000 will be income taxed this year. The Roth withdrawal will increase the family’s EFC for two years from now, but so will all the others remaining.
Sharon’s traditional IRA is third. It will produce $4,000 of taxable income, but neither IRA will be subject to the early withdrawal penalty. Higher education costs are an exception to the 10% penalty for IRAs, but not qualified retirement plan withdrawals.
They might be able to get the money out of Sharon’s Section 401(k) plan as a hardship withdrawal, but it would be both taxed and 10% penalized. If the Section 401(k) plan offered a loan, taking a loan would be better than taking a hardship withdrawal because the loan would escape both the income tax and the early withdrawal penalty.
Jane wants to withdraw $4,000 at the beginning of each year for the next seven years from her investment account. She expects to earn a 10.5% rate of return compounded annually on her investment. What lump sum should Jane deposit today?
Answer: $21,168.72
BEG mode
PMT: 4,000
I/YR: 10.5
N: 7
FV: 0
Solve for PV= $21,168.72
Mr. and Mrs. Claiborne, both age 40, have provided their financial planner with the following information:
Statement of Financial Position
Cash $4,000
Credit Cards $25,000
Traditional IRA $25,000
Student Loans Outstanding $20,000
Investments $40,000
Personal Residence Mortgage Outstanding $200,000
Personal Residence $240,000
Statement of Cash Flows
Annual Income $250,000
Annual Expenditures:
Housing Payments (PITI) $25,062
Credit Card Payments $10,000
Student Loan Payments $5,000
What is Mr. and Mrs. Claiborne’s net worth?
$64,000.
Net worth is defined as assets minus liabilities.
The statement of cash flows is irrelevant to this question.
Total assets = $309,000 ($4,000 + $25,000 + $40,000 + $240,000). Liabilities = $245,000 ($25,000 + $20,000 + $200,000).
Net worth = $64,000 ($309,000 - $245,000).
Housing Cost Ratio
mos housing cost / mos gross income
Should not exceed 28% of gross monthly income
Zoe invested $50,000 into a speculative limited partnership that is now worth $56,800. If Zoe’s annual rate of return has been 2.13%, compounded quarterly, how long has she held the limited partnership?
The answer is six years.
END Mode
4, DOWNSHIFT, P/YR
C ALL
50,000, +/-, PV
56,800, FV
2.13, I/YR
Solve for N = 24.0 ÷ 4 = 6.0025, or 6 years rounded.
Tina wants to purchase a home 6 years from today for $150,000. To attain this goal, how much should Tina invest at the end of each 6-month period if she expects to earn a 12% annual rate of return, compounded semiannually, on her investments?
END mode
FV = 150,000
I/YR = 6 (12 ÷ 2)
N = 12 (6 × 2)
PV = 0
Solve for PMT= $8,891.55
Life Cycle Phases
- Asset accumulation phase 20-45 y/o
- Conservation/protection phase 45-60
- Distribution/gifting phase 60 & up
SERIAL PAYMENTS
Assume Craig wants to save $50,000 (in today’s dollars) for his son’s college expenses in 5 years. Craig is comfortable using an inflation rate of 4% and an investment rate of return of 8%. Calculate the serial payment that Craig will make at the end of the third year.
The answer is $10,415.99.
Step 1: Determine PMT at the beginning of the first year.
50,000 FV
5 N
3.8462 I/YR [(1.08 ÷ 1.04) – 1] × 100 = 3.8462
Solve for PMT = 9,259.7823, or $9,259.78
Step 2: Multiply by 1 + inflation rate, to find the payments due at the end of each year.
$9,259.78 × 1.04 = $9,630.17 (first year)
$9,630.17 × 1.04 = $10,015.38 (second year)
$10,015.38 × 1.04 = $10,415.99 (third year)
