financial. planning.doc.docx

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Fundamentals of Financial Planning

What Is It?Financial planning is the process of solving financial problems and achieving financial

goals by developing and implementing a personalized "game plan." In order to be

effective this "plan" must take into consideration an individuals overall picture. It

must be:

coordinated

comprehensive continuous

Financial planning is like all other phases of life; it involves choices

Spend now or save for later?Pay off existing bills or increase retirement savings?Focus savings rupees on short term or long term goals?

A true financial plan does not focus one aspect or product, but instead seeks to take all

areas of planning into consideration when making financial decisions.


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What is Included? 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 ManagementThis 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 ManagementThis 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 ManagementAlmost 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 ManagementBy 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.

We will examine each of these areas in more detail.


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Why Plan?Anyone who has financial challenges to solve or financial goals to achieve needs

financial planning. Financial Planning can help to achieve both greater wealth and

financial security. Inadequate or improper planning can be financially disastrous. An

uninsured loss can wipe out accumulated wealth; insufficient savings for retirement

can force a reduced lifestyle and/or postponement of retirement; and improper tax

planning can result in higher than necessary taxes causing dollars to be lost to an

accumulation plan or to ones heirs.

Why Do People Fail to Plan? They may feel they do not have enough income or financial assets to consider

planning.

They may believe that they are too young/old to begin planning. They may be reluctant to consider some of the less pleasant aspects of planning

such as thinking about death, disability, illness, etc.

They may believe that financial planning is too expensive

THEY MAY PROCRASTINATE! (The Number One Reason For Failure)

The Steps in Financial Planning Identify Goals and Objectives: Gather the necessary data Analyze present situation and consider alternatives Develop strategies to achieve goals. Implement the strategies Review and Revise periodically


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Cash Management and BudgetingCash 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 & Savings1) 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 forlonger 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 too 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 insuredagainst the failure of the institution up to Rs.100,000 per account.


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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 of15% of gross income is a good target,although you may not be able to achieve this goal all at once. Some savings vehiclesavailable through traditional financial institutions or through brokers are:

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 Valueis the amount to which todays investment will grow over a givenperiod of time at a specific rate of interest. This process is referred to as

"compounding."


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ExampleAssume 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 probleminvolves 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.
http://learningforlife.fsu.edu/course/fp101/FutureValue.htmhttp://learningforlife.fsu.edu/course/fp101/FutureValue.htm


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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 again locate 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", andis 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 .
http://learningforlife.fsu.edu/course/fp101/FutureValueAnnuity.htmhttp://learningforlife.fsu.edu/course/fp101/PresentValue.htmhttp://learningforlife.fsu.edu/course/fp101/PresentValue.htmhttp://learningforlife.fsu.edu/course/fp101/FutureValueAnnuity.htm


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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.

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 years of your child's college education. You believe you can

achieve a 12% yield on your funds during this time.

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 Table at 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 for each of the

following three years.
http://learningforlife.fsu.edu/course/fp101/PresentValueAnnuity.htmhttp://learningforlife.fsu.edu/course/fp101/PresentValueAnnuity.htmhttp://learningforlife.fsu.edu/course/fp101/PresentValueAnnuity.htmhttp://learningforlife.fsu.edu/course/fp101/PresentValueAnnuity.htm


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Preparation of Personal Financial StatementsThe 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 Budgeting1. 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 personalexpenses. 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 topayments 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.)


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

5. The next step in the budgeting process involves preparing projectedincomeand 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 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 DifferenceHousehold Expenses

Food

Clothing

Transportation

Personal

Insurance

Professional

Debt Repayment

Miscellaneous

Savings and Investment

Grand Total


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THE PERSONAL FINANCIAL STATEMENT

Why Prepare a Personal Financial Statement?The Financial Statement is like a snapshot of your financial condition as of a certaindate. 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:

AssetsAssets 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 quicklyconverted 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, ratherthan 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.) Personal Property Movable property usually held for personal use

(automobile, furniture, clothing, etc. These assets generally depreciate

(decrease) in value.

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


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Current Liabilities Bills that are currently due and will be paid off withinone year (Rent, Current Months unpaid utility bills; medical bills; credit card

balances, etc.)

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

Net WorthNet 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 StatementImportant areas to examine are:

Net Worth If your familys net worth is less than zero, than you areinsolvent. A familys net worth should increase over time.

Solvency Ratio This calculation shows how much of a financial cushion youhave in relation to your financial obligations.

Liquidity Ratio This calculation shows how long you could pay your currentbills from your assets.


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Understanding the Use of CreditAppropriate 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 (autorepairs, medical expenses, etc.) when cash is not available.

Record-Keeping Credit borrowing provides an itemized record of alltransactions.

Opportunity Consumer can make unanticipated purchases when cashresources are not available

Facilitation of Transaction Consumer can make certain purchases indirectlyby 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 othertransactions 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..


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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 andservices. (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.

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 issuercalculates 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 anypayments 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 balanceoutstanding at the end of the previous billing cycle. This is the most


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expensivemethod 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 notcharge 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 theentire 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 RETURNSThere 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


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FILING STATUSThe 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

GROSS INCOME DEFINEDThe 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 perquisiteobtained 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


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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 scientificresearch association or a sports promotion association.

SOURCES OF INCOME EXCLUDABLE FROM TAXATIONSection 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 IncomeUnder the constitution of India , taxation of agricultural income eis 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 cropsetc. and secondary operations like removal, digging, etc. can be classified 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.


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B. Receipt by a member out of a HUF incomeAny 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 firmAny 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 receiptsAny 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


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Receipts arising from business or from exercise of profession oroccupation

Receipts by way of addition to the remuneration of an employee

E. Amount received under a life insurance policy- including the bonusallocated on such policyAny amount received under a life insurance policy including a bonus

either on maturity of the policy, or otherwise, is exempt from tax.

However, this exemption is not available to receipts under a Keyman

Insurance Policy.

F. Payments from Public Provident FundAny 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.1500Any 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 shareholderAny 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.


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J. Awards and RewardsAny 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 Param Vir Chakra or

Maha Vir 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 typesThe 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 INCOMEA. An individual assessee can claim a deduction (u/s 80 CCC) for any amountpaid 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 inrespect 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 orchildren, and

b) In case of a Hindu Undivided Family on the health of any member ofsuch 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 separatededuction 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 assessee 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 ofdonations made to certain funds, charitable institutions.

E. An assessee can claim a deduction for the interest received on the followingSecurities:

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


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Interest on deposits under such National Deposit Scheme as may beframed by the Central Government and notified by it in this behalf

in the official gazette;

Interest on deposits under the Post Office( Monthly IncomeAccount).

F. An assessee 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 CREDITSOnce 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 IncomeEquals: Adjusted Gross Income (AGI)Less Larger of Itemized or Standard DeductionsLess ExemptionsEquals Taxable IncomeTimes: Applicable Tax RateEquals Tax LiabilityLess Tax Credits and PrepaymentsEquals Tax or Refund Due


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TAX PLANNING AND ITS ROLE IN THE FINANCIALPLANNING PROCESSTaxpayers 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 OptionsThis technique involves the maximization of available tax deductions, exemptions and

credits (thereby reducing the amount of taxable income). These issues will vary byindividual and should generally be discussed with a tax professional; however, someof the more important considerations are:

o Are you aware of all available exemptions, deductions and credits towhich you are entitled?

o Is your present taxpayer status (joint return, separate return, Head ofHousehold, etc.) best for you?

o Will your AMT calculation exceed your regular tax calculation; and ifso, 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 TechniquesIncome tax liability can frequently be reduced though the techniques of deferral or

acceleration.


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o Acceleration: Income may be accelerated (taken early) so as to includeit 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

make sense if taxable income was anticipated to be higher than in the

current income period.

3) Utilization of Non-Taxable Employee BenefitsYou 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 notconsidered taxable income.)


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o Group term life insurance (death benefits of up to Rs.50,000 in mostcases, are exempt from taxation.)

o Group accidental death and dismemberment, travel accident andrelated 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 incomeproducing property (such as stock, savingsbonds, certain real estate, etc.) In this case, all future income will betaxed 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, theproperty itselfmust be given away; since gifts ofonly theincomewill 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 isaccomplished 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 investmentsales in order tomaximize your tax advantage. If you have capital gains on securities or


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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.

o "Tax exchanges" are available which will permit the sale of a securityfor 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 differenttechnology stock; thereby keeping your position in

a technology investment. (Note: tax laws concerning this typetransaction are somewhat complicated, so you should consult with yourtax professional for personal advice before undertaking this strategy.)

o Tax laws permit a taxpayer to select which stock/fund shares they wantto 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



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).


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o Since capital gains laws favor investments held for periods of at least 12months, (See Capital Gains Above), 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 casho Gifts of appreciated property such as stock or real estate (These gifts

would generally be deductible at fair market value on the date of thegift, 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 istransferred to the trust, with the donor receiving and income stream

from the investment, and the charity receiving the property. The

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 TaxReform Act of 1986. This was intended to discourage taxpayers from investing in a

particular activity strictly for tax purposes.


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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 isgenerally of interest only to the higher tax brackets, due to the fact that at lowerbrackets, these bonds would not have as high a return as the taxable bonds even afterthe 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 planso Employee Stock Options Planso Non-Qualified deferred compensation Planso 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.


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

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 investmentgrowth 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 theuse of these funds prior to retirement age (59 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.


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Insurance Planning and Risk ManagementThe BasicsRisk 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.

ExampleThe 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 involveslowering the probability of a particular hazard occurring; and lessening theseverity of the hazard by taking some positive action.


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ExampleA 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 therisk. 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, manypeople 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.

ExampleChoosing 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 toaccept part of the potential liability for a certain hazard.

ExampleThe selection of an insurance policy (health, auto, or homeowners)

with a large deductible would involve partial retention.


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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.

Life InsuranceThe 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 stateestate 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 otherfamily member

Liquidity emergency fund; necessary immediate cash flow Bequests church, school, family members, friends employees, charities


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Funding of established financial goals completing college funding; purchaseof 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 whatavailable 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 beexpressed 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 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 isdetermined, the next decision is what kind to purchase.


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Kinds of Life Insurance

What Kind of Life Insurance Should I Purchase?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 InsuranceTermis insurance that is purchased for a certain period of time (its term). Duringthat 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 lessexpensive 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 LifeThis is the oldest form of permanent/cash value life insurance. It features a

guaranteed premium; a guaranteed cash value; and a guaranteed death benefit. Thecash value earns a minimum guaranteed rate of return, and may also receive

dividends or additional interest.


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3) Endowment policyEndowment 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 notalways the best.

Comparative Policy Benefits:- The policy provisions, guarantees, historicalperformance 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 companysfinancial 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 mostable 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 meetyour needs. Remember, there is no one policy that is right for all situations.


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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 metstatutory requirements).

The growth of cash value within the life insurance contract grows on a tax-deferredbasis. 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 surrenderedwith the loan still outstanding.

Dividends paid on Whole Life policies are non-taxable, since they areconsidered 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 theestate, and generally are not subject to estate debts but may be subject to estate

tax.

In most states, creditors are prevented from penetrating accumulated cashvalues in life insurance policies in the event of lawsuit or bankruptcy.


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Health InsuranceThe 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 InsuranceWhat 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


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2) Disability Income InsuranceThe 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



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.


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


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

o Section I Property Loss Exposure which covers a loss of any of thefollowing due to a peril stated in the policy:

A. - DwellingB. - Other StructuresC. - Personal PropertyD. - Loss of Use

o Section II Liability Loss Exposure (E) which covers personal liability(lawsuit protection) and Medical Payments to Others (F)

oThe Personal Property Floater (PPF) is a rider which providesadditional 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(ifthe insured wants the coverage to apply.)


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On What Is Coverage Based?Generally coverage on the dwelling includes the amount necessary to repair, rebuild

orreplace an asset at todays prices is covered, ifthe 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 tobe 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. Ifyou 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.

What Factors Affect My Auto Premium Rates?Some of the factors affecting premium are:

o Geographic Location of Coverage ("Rating Territory")- Somegeographic 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 affectpremiums. Young drivers are in higher classes than others.

o Type of Auto to be Insured An autos 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 forDUI will incur higher rates than safe drivers.


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Investment PlanningThe Basics

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 willgrow 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.

Get Started

Ask yourself these questions:

What will be the source of my investment capital? (Where will the moneycome from to invest?)

The most common source of capital is any excess of family income over family

expenses. Other sources may include inheritances, gifts, growth of investmentsor business interests, or distributions from retirement plans, etc. These

investment sources may include lump sums orperiodic investing or both. What is (are) my investment goal(s)?

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 childrens 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.


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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 goal(s)?Future Value methods may beused 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.

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) RiskThere 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.
http://learningforlife.fsu.edu/course/fp101/FP-Fundamentals-Text.htm#cm1c1http://learningforlife.fsu.edu/course/fp101/FP-Fundamentals-Text.htm#cm1c1http://learningforlife.fsu.edu/course/fp101/FP-Fundamentals-Text.htm#cm1c1


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Risk of Principal If the investment selected performs poorly, the amount ofmoney which was invested can be lost, in part or in whole.

Market/Volatility Risk The value of the investment selected may move up ordown due to changes in the particular financial market your investment is

participating in.

Purchasing Power Risk This is uncertainty over the future purchasing powerof 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 asbonds, 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.

ExampleYou 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


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which have increased over that same time period.

Tax Risk This involves the potential tax consequences involved with aparticular investment to include federal and state income, estate, inheritance

and gift taxes.

2) Rate of ReturnExpected future return is what causes an investor to select an investment. And, sincethe 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 totalamount of earnings on an investment is "total return". And this is generally brokendown 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 investmentvehicle. This return is generally not received or recognized until the asset is

sold.

Another factor affecting Rate of Return is the potential effect ofcompounding

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

compounding.


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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 itsexpected 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 ReturnIt has been said that it doesnt matter what you get; only what you get to keep! Forthis 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

investors income tax rate.

ExampleIf Mr. Fletcher, who is in the 28% tax bracket, invested in a

Certificate of Deposit which was paying 6% interest, his After-Tax


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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 didnt 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 fromsome municipal bonds. So, the after-tax yield for a fully tax-exempt

investment equals the Current Yield.

ExampleSo, 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 andrecognized 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


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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.

4) Marketability and LiquidityThese 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 whichan investment can be readily traded.

Liquidity refers to the ability to readily convert an investment into cashwithout 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.


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ExampleChecking 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) DiversificationDiversification is an important investment policy to consider in constructing aportfolio. 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.


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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.

Kinds of InvestmentsThere are many investment vehicles available. But in general, all forms of

investments may be divided into "Debt" and "Equity" investments. Anytime you allowsomeone 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 moderatereturns. 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).


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1) Debt InvestmentsWhat 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 paidin full at maturity.)

What Types of Bonds are there?Bonds may also be classified as "callable" or "non-callable". Callable bonds contain aprovision 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

years interest) is generally payable to the investor, if the bond is called.


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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 Indiaand 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 specificallyfor 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 anytimeafter 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 anindividual 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 theinvestors linked to the yields on Government of India securities.


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2) Equity InvestmentsWhat 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

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 onyour investment. As a shareholder, you will have the right to vote on companydecisions.


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Why Should I Consider Investing In Stocks?Most investors who purchase common stock do so based on theirpotential forrelatively high returns, but there are other factors to consider.

An investment may yield income that is tax exempt, such as interest fromsome 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 mostcommon method of categorizing.

o Blue Chip Stocks These are stocks of high quality with long and stablerecords 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 ofgrowth in operations and earnings.

o Income Stocks These are stocks that are selected primarily for thedividends they pay. They have been able to demonstrate a stable stream

of earnings.

o Speculative Stocks These are stocks of companies which may beexpected 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.


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o Cyclical and Defensive Stocks- Cyclical stocks are those whosemovement 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.

Another method of categorizing stocks is by "Market Capitalization" orSize. This usesthe stocks 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. (Thesestocks 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 $4billion. (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 billionHow 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 aremany 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!


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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 aredependent upon earnings, a stocks 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 perShare", and attempts to measure the amount of assets a corporation has

working for each share of common stock. It is computed by subtracting

the companys 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 stockdivided by the current per share earnings of the corporation.

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

o Beta This indicates the price volatility in relation to the Market as awhole (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

direction as the Market; while negatives move in the opposite

direction.


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Other Equity InvestmentsAlthough 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 myInvestment Portfolio?Real Estate Real estate has historically been useful in a portfolio for both incomeand capital gains. Home ownership, in itself, is a form of equity investment, as is theownership 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 acertain 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.


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Commodity Futures Trading A futures contract is an agreement to buy or sell acommodity (wheat, corn, oats, soybeans, copper, silver, lumber, etc.) at a price stated

in the agreement on a specified future date.

3) Mutual Funds InvestmentsWhat 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 fromthe 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 funds portfolio. Net Asset Value (NAV)is based on the current valueof all securities held in the funds portfolio, and represents the price at which the

investor can sell his/her shares.

Closed-End Investment Companies Closed end companies operate with a fixednumber 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.


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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 adividend, 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 stockholdings 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.).


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3. Increase in Share Value Above Purchase Price The share ofthe 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

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