A solid understanding of personal finance will

Personal Finance

1 Understanding Personal Finance

YOU MUST BE KIDDING, RIGHT?

Lauren Crawford invests $300 per month through her employer-sponsored 401(k) retirement account. If the investments she has chosen average an 8 percent annual return, how much money will she have in the account over and above the amounts contributed after 35 years?

A. $126,000

B. $352,800

C. $562,200

D. $688,200

The answer is C, $562,200 ($688,200 − $126,000). Lauren will contribute $126,000 ($3600 × [$300 × 12] × 35). Lauren makes the big money ($562,200) from “the annual compounding of money, “ not just on the amounts she puts into her retirement plan each month. Growing wealth is all about the magic of compound interest!

LEARNING OBJECTIVES

After reading this chapter, you should be able to:

Recognize the keys to achieving financial success.

Understand how the economy affects your personal financial success.

Apply basic economic principles when making financial decisions.

Perform time value of money calculations in personal financial decision making.

Make smart decisions about your employee benefits.

Identify the professional certifications of providers of financial advice.

WHAT DO YOU RECOMMEND?

Na Yeon Choi, age 23, recently graduated with her bachelor’s degree in library and information sciences. She is about to take her first professional position as an archivist with a large civil engineering firm in a rapidly expanding area in California. While in school, Na Yeon worked part time for that firm, earning about $10,000 per year. For the past two years, she has managed to put $1000 each year into an individual retirement account (IRA). Na Yeon owes $35,000 in student loans on which she is obliged now to begin making payments. Her new job will pay $55,000. Na Yeon may begin participating in her employer’s 401(k) retirement plan immediately, and she can contribute up to 8 percent of her salary to the plan. Her employer will contribute 1/2 of 1 percent for every 1 percent that Na Yeon contributes.

What do you recommend to Na Yeon on the importance of personal finance regarding:

1. Participating in her employer’s 401(k) retirement plan?

2. Understanding the effects of her marginal tax rate on her financial decisions?

3. Considering the current state of the economy in her personal financial planning?

4. Using time value of money considerations to project what her IRA might be worth at age 63?

5. Using time value of money considerations to project what her 401(k) plan might be worth when she is age 63 if she were to participate fully?

YOUR NEXT FIVE YEARS

In the next five years, you can start achieving financial success by doing the following related to understanding personal finance:

1. Stay up to date with current economic conditions.

2. Use marginal and opportunity costs and time value of money calculations when making financial decisions.

3. Harness the power of compounding by starting early to save a consistent amount each month for long-term goals.

4. Take responsibility for managing your own financial success.

5. Take advantage of tax sheltering through your employer’s benefits program.

Can you successfully manage your personal finances in today’s economy? Yes you can. But it will be challenging. Most people now realize that consuming less, paying off credit cards, and saving and investing more are the keys to long-term financial stability and success. That is good advice for you, too. In the years ahead many opportunities will arise for you to take smart actions to help assure your future financial success. You can do these things if you put in practice what you will learn in your personal finance course.

Personal finance is the study of personal and family resources considered important in achieving financial success; it involves how people spend, save, protect, and invest their financial resources. Topics in personal finance include financial and career planning, budgeting, tax management, cash management, credit cards, borrowing, major expenditures, risk management, investments, retirement planning, and estate planning. A solid understanding of personal finance topics offers you a better chance of success in facing the financial challenges, responsibilities, and opportunities of life. The best of all the successes is the sense of freedom from financial worries that comes with effectively planning your personal finances.

personal finance The study of personal and family resources considered important in achieving financial success; it involves how people spend, save, protect, and invest their financial resources.

You are fortunate to be reading this book as it provides prudent guidance for every step of the way. Careful study will enhance your financial literacy , which is simply your knowledge of facts, concepts, principles, and technological tools that are fundamental to being smart about money. Financial literacy empowers you. It improves your ability to handle day-to-day financial matters, helps you avoid the consequences of poor financial decisions that could take years to overcome, helps you make informed and confident personal money decisions, and makes you more financially responsible.

financial literacy Knowledge of facts, concepts, principles, and technological tools that are fundamental to being smart about money.

Financial responsibility means that you are accountable for your future financial well-being and that you strive to make good decisions in personal finance. The biggest example of not being financially responsible is to live like you are rich before you are. Being financially responsible means you will control your personal financial destiny and be successful. At the beginning of each chapter, we provide a short case vignette titled “What Do You Recommend?” Each story focuses on the financial challenges that can be experienced by someone who has not learned about the material in that chapter. You will be asked to think about what advice you might give the person as you study the chapter. Then at the end of each chapter, you will again be asked to provide more informed advice based on what you have learned. You will be much better informed then!

financial responsibility Means that you are accountable for your future financial well-being and that you strive to make wise personal financial decisions.

1.1 ACHIEVING PERSONAL FINANCIAL SUCCESS

LEARNING OBJECTIVE 1

Recognize the keys to achieving financial success.

Today’s marketplace provides a constant barrage of messages suggesting that you can spend and borrow your way to financial success, security, and wealth. Well, they are wrong because you can’t. These messages are very enticing for those starting out in their financial lives. In truth, overspending and overuse of consumer credit seriously impede financial success.

Many people think that being wealthy is a function of how much you earn or inherit. In reality, it is much more closely related to your ability to make good decisions that generate wealth for you.

Consider accepting some advice from your grandparent’s generation: “Be responsible for yourself. Be frugal. Work hard. Keep a level head. Use common sense. And above all, never give up on what you love.”

DID YOU KNOW

In Life and Career We Must Learn to “Focus”

Daniel Goleman’s book Focus: The Hidden Ingredient in Excellence offers tips for getting more out of our lives and careers as well as our roles as parents and as partners. He argues that the secret to high performance and fulfillment is “attention.” Goleman says that we must learn to sharpen our focus if we are to contend with, let alone succeed in, a complex world. We are overwhelmed by so much stuff in life (e.g., e-mails, texts, smart phones, Facebook) that we hardly enjoy a relaxed conversation, listening, and even quietly enjoy our meals. Goleman’s research focuses on three types of listening: inner, other, and outer focus. Paying careful attention is a capability that can be learned because it will enhance one’s emotional intelligence and performance.

You have to do only a few things right in personal finance during your lifetime, as long as you don’t do too many things wrong. Personal finance is not rocket science. You can succeed very well in your personal finances by making appropriate plans and taking sensible actions to implement those plans.

1.1a Plan for Financial Success and Happiness

Financial success is the achievement of financial aspirations that are desired, planned, or attempted. Success is defined by the person who seeks it. Some define financial success as being able to actually live according to one’s standard of living. Many seek financial security , which provides the comfortable feeling that your financial resources will be adequate to fulfill any needs you have as well as most of your wants. Others want to be wealthy and have an abundance of money, property, investments, and other resources.

financial success The achievement of financial aspirations that are desired, planned, or attempted, as defined by the person who seeks it.

financial security The comfortable feeling that your financial resources will be adequate to fulfill any needs you have as well as most of your wants.

Financial happiness encompasses a lot more than just making money. It is the experience you have when you are satisfied with your money matters. People who are happy about their finances are likely to be spending within a budget and taking steps to achieve their goals, and this happiness spills over in a positive way to feelings about their overall enjoyment of life. Financial happiness is in part a result of practicing good financial behaviors. Examples of such behaviors include paying bills on time, spending less than you earn, knowing where your money goes, and investing some money for the future. The more good financial behaviors you practice, the greater your financial happiness. In fact, simply setting financial goals contributes to financial happiness.

financial happiness The experience you have when you are satisfied with your money matters, which is in part a result of practicing good financial behaviors.

DID YOU KNOW

Bias Toward Thinking Negatively

People engaged in the understanding personal finance have a bias toward certain behaviors that can be harmful, such as a tendency toward thinking negatively about their level of living. These people compare their personal finances to others a lot and care about the results.

And, they tend to feel better when others are doing poorly. What to do? Focus on your own goals and resist comparing your situation to others.

DID YOU KNOW

The Five Fundamental Steps in the Financial Planning Process

There are five fundamental steps to the personal financial planning process: (1) Evaluate your financial condition relative to your education and career choice; (2) define your financial goals; (3) develop a plan of action to achieve your goals; (4) implement your plan; and (5) review your financial progress and make changes as appropriate.

As indicated in step 5, this process is revisited periodically, ideally every year, and whenever your life takes a meaningful turn such as a new job, marriage, birth of a child, or even after a sad event such as a divorce or death of a family member.

1.1b Spend Less So You Can Save and Invest More

Financial objectives are rarely achieved without forgoing or sacrificing current consumption (spending on goods and services). This restraint is accomplished by putting money into savings (income not spent on current consumption) for use in achieving future goals. Some savings are actually investments (assets purchased with the goal of providing additional future income from the asset itself). By saving and investing, people are much more likely to have funds available for future consumption. If you save for tomorrow, you will be happier today and tomorrow.

savings Income not spent on current consumption.

investments Assets purchased with the goal of providing additional future income from the asset itself.

Effective financial management often separates the haves from the have-nots. The haves are those people who learn to live on less than they earn and are the savers and investors of society. The have-nots are the spenders who live paycheck to paycheck, usually with high consumer debt. They fail to manage money and as a result money manages them.

Being frugal is not about abstinence. It is about being smart in personal finance. Saving money does not make you cheap; it makes you smarter than those who just spend and spend. Spending less is about prioritizing your choices. You should think about making good choices in life when making every day spending decisions by asking yourself “What is most important to me?” This helps you get out of the habit of simply spending money and making choices that will enhance your life.

Figure 1-1 Building Blocks to Achieving Financial Success Figure 1-2 How to Get Your Financial House in order by Age 30

Saving for future consumption represents a good illustration of the human desire to achieve a certain standard of living . This standard is what an individual or group earnestly desires and seeks to attain, to maintain if attained, to preserve if threatened, and to regain if lost. Our standards include our wants and needs—our comforts and luxuries too. In contrast, individuals actually experience their level of living at any particular time. In essence, your standard of living is where you would like to be, and your level of living is where you actually are.

standard of living Material well-being and peace of mind that individuals or groups earnestly desire and seek to attain, to maintain if attained, to preserve if threatened, and to regain if lost.

Figure 1-1 shows the building blocks to achieving financial success and how they fit together. Figure 1-2 shows how to get your financial house in order by age 30. Accomplish these steps and you will be financially successful.

FINANCIAL POWER POINT

Dreams Are Not Goals

Everybody has dreams about financial success. But only by setting clear financial goals with specific plans for their achievement will you achieve financial success in the future.

CONCEPT CHECK 1.1

1. Distinguish among financial success, financial security, and financial happiness.

2. Explain the five fundamental steps in the financial planning process.

3. What are the building blocks to achieving financial success?

1.2 THE ECONOMY AFFECTS YOUR PERSONAL FINANCIAL SUCCESS

LEARNING OBJECTIVE 2

Understand how the economy affects your personal financial success.

Your success in personal finance depends in part on how well you understand the economic environment; the current stage of the business cycle; and the future direction of the economy, inflation, and interest rates.

DID YOU KNOW

Your Worst Financial Blunders in Understanding Personal Finance

Based on other’s financial woes, you will make personal finance mistakes when you:

1. Only think about money matters when you have a financial problem

2. Spend more than you earn

3. Believe and act on financial advice from amateurs rather than trust professional sources

1.2a How to Tell Where We Are in the Business Cycle

An economy is a system of managing the productive and employment resources of a country, state, or community. The U.S. federal government attempts to regulate the country’s overall economy to maintain stable prices (low inflation) and stable levels of employment (low unemployment). In this way, the government seeks to achieve sustained economic growth , which is a condition of increasing production (business activity) and consumption (consumer spending) in the economy— and hence increasing national income. Government policies also affect the economy. For example, tax cuts keep money in consumers’ pockets, money that they are then likely to spend. Tax increases, in contrast, depress consumer demand.

economic growth A condition of increasing production (business spending) and consumption (consumer spending) in the economy and hence increasing national income.

1.2b The Business Cycle

Growth in the U.S. economy varies over time. The business cycle (also called the economic cycle ) is a process by which the economy grows and contracts over time. It can be depicted as a wavelike pattern of rising and falling economic activity in which the same pattern occurs again and again over time. As illustrated in Figure 1-3 , the phases of the business cycle are expansion (when the economy is increasing), peak (the end of an expansion and the beginning of a contraction), contraction (when the economy is falling), and trough (the end of a contraction and beginning of an expansion).

business cycle/economic cycle Business cycles can be depicted as a wavelike pattern of rising and falling economic activity; the phases of the business cycle include expansion, peak contraction (which may turn into recession), and trough.

The preferred stage of the economic cycle is the expansion phase, where production is at high capacity, unemployment is low, retail sales are high, and prices and interest rates are low or falling. Under these conditions, consumers find it easier to buy homes, cars, and expensive goods on credit, and businesses are encouraged to borrow to expand production to meet the increased consumer demand. The stock market also rises because investors expect higher profits in the future.

As the demand for credit increases, short-term interest rates rise because more borrowers want money. Consumers and businesses purchase more goods, exerting upward pressure on prices. Eventually, prices and interest rates climb high enough to stifle consumer and business borrowing, send stock prices down, and choke off the expansion. One effect of such economic turmoil is deleveraging , meaning that instead of normal economic times when credit usage grows, it shrinks because companies and individuals pay down their debts. When businesses and consumers use less debt, home and car sales decline as does employment. The result is a period of negligible economic growth or even a decline in economic activity.

deleveraging A time period when credit use shrinks in an economy instead of expanding as during normal economic times.

In such situations, the economy often contracts and moves toward a recession . During recessions, consumers become pessimistic about their future buying plans. The typical U.S. recession is marked by an average economic decline of 2 percent that lasts for ten months with an average unemployment rate exceeding 6 percent.

recession A recurring period of decline in total output, income, employment, and trade, usually lasting from six months to a year and marked by widespread contractions in many sectors of the economy.

There have been five recessions since 1980. The federal government’s Business Cycle Dating Committee of the National Bureau of Economic Research officially defines a recession as “a period of falling economic activity spread across the economy, lasting more than a few months, normally visible in real gross domestic product, real income, employment, industrial production, and wholesale-retail sales.”

The Aftermath of the Great Recession The Great Recession began in December 2007 and ended in June 2009. The recession lasted 18 months, which makes it the longest of any recession since World War II.

The economy contracted 5.1 percent during the Great Recession, and it was of historic proportions. It was the worst economic contraction since the Great Depression of 1929–1941. During the Great Recession nine million people in the United States had their jobs disappear as unemployment surpassed 10 percent. Half of all American workers suffered job losses, pay cuts, or reduced hours at work, or they were forced into part-time employment.

Figure 1-3 Business Cycle Phases

Many people of your parents’ ages saw the value of their homes shrink 25 to 65 percent while at the same time half of their retirement funds evaporated. The Great Recession destroyed 20 percent of American’s wealth in home values and investments. Surveys revealed that over 60 percent of those between age 50 and 61 have had to delay their retirements, and the average retirement age rose three years since 2008. Consumer confidence dropped to an all-time low.

Years later the U.S. economy is still dealing with the aftermath of the Great Recession. We continue to experience slow economic growth and relatively high unemployment. It took four years (until 2013) for stock prices to recover and to see home prices recover in most communities.

FINANCIAL POWER POINT

Double Dip Recession

Some people fear that continued downward pressure from relatively weak wages and demand may result in a double dip recession. This occurs when the economy has a recession and then, soon after emerging from the recession with a short period of growth, falls back into recession.

The Economic Future … Eventually … Will Be Expansion Despite the severity or length of any recession, eventually the economic contraction ends, and consumers and businesses become more optimistic. The economy then moves beyond the trough toward recovery and expansion, where levels of production, employment, and retail sales begin to improve, allowing the overall economy to experience some growth from its previously weakened state. The entire business cycle typically takes about six years.

Politicians and economic advisors struggle with which path to take to create economic growth. Most of the world has followed the Keynesian economic theory since the 1930s, which is to increase demand with stimulus spending even if it creates large temporary government deficits. The logic is that when consumers and businesses spend less, the economy will be depressed unless the government spends more. Such spending creates additional economic growth that results in increased tax revenues, thus resulting in budget surpluses that can be used to pay down the debts. * Now, however, the deficits themselves are seen as the problem by some U.S. politicians and in other countries resulting in calls to slash public outlays. Others say such an austerity approach will lead to lower demand, lower growth, lower tax revenues, stock market declines, and an even higher national debt, as has occurred in Greece, Ireland, Portugal, Spain, and Great Britain.

FINANCIAL POWER POINT

You Can Be optimistic About Your Future

During slow or sluggish economic times people face uncertain financial futures. However, this does not mean that they should stop saving and investing for their futures. Every generation has faced similar uncertainties. You should be positive about the long-term economic future. Make sound, prudent decisions regarding spending, saving, and investing by putting in practice what you learn in this book.

No matter what path is chosen, the 2007 to 2009 contraction of the economy will have costly after effects in the United States for years to come, including the new normal of slower job growth, slimmer paychecks, less borrowing, lower consumer spending, and higher savings.

The Congressional Budget Office says that given the severity of the Great Recession, it could take until 2022 or 2023 for unemployment to get back to the more typical 5 or 5% percent and see the economy return to a healthy growth rate of 3+ percent annually. The U.S. economy has to grow around 2.5 percent a year just to keep up with rising productivity and population growth, and to keep unemployment from rising.

1.2c How to Tell the Future Direction of the Economy

To make sound financial decisions, you need to know where we are in the business cycle, how well the economy is doing, and where the economy might be headed. You can do this by paying attention to some economic statistics that are regularly reported in the news as well as on cable TV business shows. Your knowledge can help guide your long-term financial strategy. An economic indicator is any economic statistic, such as the unemployment rate, GDP, or the inflation rate (terms discussed in the next few paragraphs), that suggests how well the economy is doing and how well the economy might do in the future.

economic indicator Any economic statistic, such as the unemployment rate, GDP, or the inflation rate, that suggests how well the economy is doing now and how well it might be doing in the future.

Look at Procyclic Indicators, like GDP and Jobs A procyclic (or procyclical) economic indicator is one that moves in the same direction as the economy. Thus if the economy is doing well, this number typically is increasing. If we are in a recession, this indicator is decreasing. Examples of procyclic indicators are retail sales, industrial production, new orders for durable goods (like household appliances), number of employees on nonagricultural payrolls, and the gross domestic product. Consumer spending accounts for about 70 percent of the total U.S. economy.

The best understood example of a procyclic economic indicator is the gross domestic product (GDP) , which is the broadest measure of the economic health of the nation because it reports how much economic activity (all goods and services) has occurred within the U.S. borders. The government regularly announces the rate at which the GDP has grown during the previous three months ( www.bea.gov/newsreleases/rels.htm ). In the United States, an annual rate of 2 percent or less is considered very low growth (not even enough to create jobs for new entrants to the job market such as college graduates), and 3 percent is considered growth occurring at a safe speed that is not likely to induce excessive inflation. A sustained rate of 4 percent or higher starts to worry economists and investors. The United States needs a GDP growth rate of about 2.5 percent just to keep unemployment from rising and much faster economic growth, such as a growth rate of 4 or 5 percent, to bring the unemployment rate significantly down.

gross domestic product (GDP) The nation’s broadest measure of economic health; it reports how much economic activity (all goods and services) has occurred within the U.S. borders during a given period.

Look at Countercyclic Indicators A countercyclic (or countercyclical) economic indicator is one that moves in the opposite direction from the economy. For example, the unemployment rate is countercyclic because it gets larger as the economy gets worse. Similarly, the price of gold rises as the economy gets worse since some people see gold as a safe haven in bad times (even though it is not).

Look at Leading Indicators Leading economic indicators are those that change before the economy changes; thus, they help predict how the economy will do in the future. The stock market is a leading economic indicator because it usually begins to decline shortly before the overall economy slows down. Then the stock market advances before the economy begins to pull out of a recession. Other examples of leading economic indicators are the number of new building permits, existing home sales, home prices, jobless claims (average number of weekly first-time filings for unemployment benefits), the Standard & Poor’s 500 Stock Index, and the consumer confidence index.

leading economic indicators Statistics that change before the economy changes, thus helping predict how the economy will do in the future, such as the stock market, the number of new building permits, and the consumer confidence index.

The consumer confidence index is a widely watched leading economic indicator that gauges how consumers feel about the economy and their personal finances. It gives a sense of consumers’ willingness to spend ( www.conference-board.org ). Growing confidence suggests increased consumer spending. Consumers worried about the future postpone purchases, and the reduced spending acts as a drag on the economy.

The index of leading economic indicators (LEI) is a composite index, reported monthly by the Conference Board, that suggests the future direction of the U.S. economy ( www.conference-board.org ). The LEI averages ten components of growth from different segments of the economy, such as building permits, factory orders, and new private housing starts. Leading economic indicators are very important to investors as they help predict what the economy will be like in the future.

index of leading economic indicators (LEI) A composite index reported monthly by the Conference Board that suggests the future direction of the U.S. economy.

1.2d The Future Direction of Inflation and Interest Rates

Prices and interest rates typically move in the same direction. A steady rise in the general level of prices is called inflation . Inflation is measured by the changing cost over time of a “market basket” of goods and services that a typical household might purchase. Inflation often occurs when the supply of money (or credit) rises faster than the supply of goods and services available for purchases. It also may be attributed to excessive demand or sharply increasing costs of production.

inflation A steady and sustained rise in general price levels across economic sectors; measured by the changing cost over time of a “market basket” of goods and services that a typical household might purchase.

Inflation Is the Typical Economic Condition Some level of inflation is the typical condition in any economy and can be beneficial in moderation as it encourages job creation and economic growth. But when there is high inflation in the United States, perhaps 5 or 6 percent workers begin to push for higher wages, thereby adding to the cost of production. In response to the increases in the costs of labor and raw materials, manufacturers will charge more for their products. Lenders, in turn, will require higher interest rates to offset the lost purchasing power of the loaned funds. Consumers will lessen their resistance to price increases because they fear even higher prices in the future. Thus, inflation can have a snowball effect. In times of moderate to high inflation, buying power declines rapidly, and people on fixed incomes suffer the most. A very negative complication of inflation that sometimes occurs is stagflation, which is the condition of stagnant economic growth and high unemployment accompanied by rising prices.

Here Is How Inflation Is Measured The U.S. Bureau of Labor Statistics measures inflation on a monthly basis using the consumer price index (CPI) . The CPI is a broad measure of changes in the prices of all goods and services purchased for consumption by urban households. The prices of more than 400 goods and services (a “market basket”) sold across the country are tracked, recorded, weighted for importance in a hypothetical budget, and totaled. In essence, the CPI is a cost of living index. The index has a base time period—or starting reference point—from which to make comparisons. The 1982 to 1984 time period represents the base period of 100. For example, if the CPI were 234 on January 1, 2015, the cost of living would have risen 121 percent since the base period [(234 − 100) / 100 = 1.34 or 134%] * . Similarly, if the index rises from 234 to 242 on January 1, 2016, then the cost of living will have increased by 3.4 percent over the year [(242 − 234) / 234 = 0.034 or 3.4%].

consumer price index (CPI) A broad measure of changes in the prices of all goods and services purchased for consumption by urban households.

Here Is How Inflation Affects Your Income From an income point of view, inflation has significant effects. Consider the case of Scott Wade of Chicago, a single man who took a job in retail management three years ago at a salary of $50,000 per year. Since that time, Scott has received annual raises of $1000, $1200, and $1500, but he still cannot make ends meet because of inflation. Although Scott received raises, his current income of $53,700 ($50,000 + $1000 + $1200 + $1500) did not keep pace with the annual inflation rate of 3.0 percent ($50,000 × 1.03 = $51,500; $51,500 × 1.03 = $53,045; $53,045 × 1.03 = $54,636). If Scott’s own cost of living rose at the same rate as the general price level, in the third year he would be $936 ($54,636 − $53,700) short of keeping up with inflation. He would need $936 more in the third year to maintain the same purchasing power that he enjoyed in the first year.

Personal incomes rarely keep up in times of high inflation. Your real income (income measured in constant prices relative to some base time period) is the more important number. It reflects the actual buying power of the nominal income (also called money income) that you have to spend as measured in current dollars. Rising nominal income during times of inflation creates the illusion that you are making more money, when in actuality that may not be true.

real income Income measured in constant prices relative to some base time period. It reflects the actual buying power of the money you have as measured in constant dollars.

nominal income Also called money income; income that has not been adjusted for inflation and decreasing purchasing power.

To compare your annual wage increase with the rate of inflation for the same time period, you first convert your dollar raise into a percentage, as follows:

For example, imagine that Javier Gomez, a single parent and assistant manager of a convenience store in Windermere, Florida, received a $1600 raise to push his $37,000 annual salary to $38,600. Using Equation (1.1), Javier calculated his percentage change in personal income as follows:

After a year during which inflation was 4.0 percent, Javier did better than the inflation rate because his raise amounted to 4.3 percent. Measured in real terms, his raise was 0.3 percent (4.3 − 4.0). In dollars, Javier’s real income after the raise can be calculated by dividing his new nominal income by 1.0 plus the previous year’s inflation rate (expressed as a decimal):

DO IT IN CLASS

ADVICE FROM A PROFESSIONAL

Seven Money Mantras for a Richer Life

1. It’s not an asset if you are wearing it!

2. Is this a need or is it a want?

3. Sweat the small stuff.

4. Cash is better than credit.

5. Keep it simple.

6. Priorities lead to prosperity.

7. Enough is enough!

Michelle Singletary

Nationally syndicated Washington Post columnist (““The Color of Money”) and author of The Power to Prosper: 21 Days to Financial Freedom.

Reprinted with permission of the author.

Clearly, a large part of the $1600 raise Javier received was eaten up by inflation. To Javier, only $115 ($37,115 − $37,000) represents real economic progress, while $1485 ($1600 − $115) was used to pay the inflated prices on goods and services. The $115 real raise is equivalent to 0.31 percent ($115 / $37,000, or less than 1 percent) of his previous income, reflecting the difference between Javier’s percentage raise in nominal dollars and the inflation rate.

Here Is How Inflation Affects Your Consumption When prices are rising, an individual’s income must rise at the same rate to maintain its purchasing power , which is a measure of the goods and services that one’s income will buy. When prices rise, the purchasing power of the dollar declines, but not by the same percentage. Instead, it falls by the reciprocal amount of the price increase (the counterpart ratio quantity needed to produce unity).

purchasing power Measure of the goods and services that one’s income will buy.

In the preceding illustration where prices increase between 2015 and 2016, prices rose 2.1 percent, whereas the purchasing power of the dollar declined 2.07 percent over the same period. [The previous year base of 237 divided by the index of 242 equals 0.9793; the reciprocal is 0.0207 (1 − 0.9793), or 2.07%.].

The Rule of 70 can be used to determine how long it will take for the value of the dollar to go down by one-half. Simply divide 70 by the current inflation rate. In our example, a 2.1 percent inflation rate would reduce the value of a dollar by one-half in 33 years (70 / 2.1). As you can see, even a low inflation rate means that by the time a young worker retires, the purchasing power of their initial income will have dropped significantly.

Rule of 70 A formula to determine how long it will take for the value of a dollar to decline by one-half.

Inflation pushes up the costs of the products and services we consume. If automobile prices rose 20 percent over the past five years, for example, then it will take $28,800 now to buy a car that once sold for $24,000 ($24,000 × 1.20). If your market basket of goods and services differs from that used to calculate the CPI, you might have a very different personal inflation rate (the rate of increase in prices of items purchased by a particular person). Inflation pushes up the cost of borrowing, so monthly car payments and home mortgage rates increase when inflation rises.

DO IT IN CLASS

Deflation Can Be Bad, Too During a severe recession there is the possibility of deflation , which is a broad, sustained decline in prices of goods and services. Deflation last occurred in the United States in 2009 as prices declined 0.34 percent during the year, and prices continued to decline during the early months of 2010. When faced with deflation, government policymakers often embark on massive spending programs to stimulate the economy. Such spending, of course, creates high national liabilities that ideally could be repaid when the economy is strong.

deflation A broad, sustained decline in prices of goods and services that is hard to stop once it takes hold, causing less consumer spending, lower corporate profits, declining home values, rising unemployment, and lower incomes.

You Can Track the Federal Funds Rate to Forecast Interest Rates and Inflation One of the mandates of the Federal Reserve Board (an agency of the federal government commonly referred to as the “ Fed ”) is to “promote maximum employment and price stability.” You can forecast interest rates and inflation by paying attention to changes in the federal funds rate , which is the short-term rate at which banks lend funds to other banks overnight so that the borrowing bank has sufficient reserves as mandated by the Fed. The federal funds rate is set by the Fed and is a benchmark for business and consumer loans and an indication of future Fed policy. The Fed lowers the federal funds rate to boost the economy in slow economic times and raises it to slow down an overheated economy. The Fed has kept the federal funds rate low for the past decade, but as the economy expands it will allow rates to go up. The Fed’s goals are inflation at 2 percent or a bit lower, interest rates at 3 percent or a bit lower, and unemployment at 5 percent or a bit higher.

fed The Federal Reserve Board, an agency of the federal government.

federal funds rate The short-term rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.

Here Is How Inflation Affects Your Borrowing, Saving, and Investing Interest is the price of money. During times of high inflation, interest rates on new loans for cars, homes, and credit cards rise. Even though nominal interest rates for savers rise as well, the increases do not provide “real” gains if the inflation rate is higher than the interest rate on savings accounts or certificates of deposit.

interest The price of borrowing money

The Fed meets regularly to discuss the economy and review federal interest rates.

Smart investors recognize that the degree of inflation risk is higher for long-term lending (5 to 20 years, for example) than for short-term lending (such as a year) because the likelihood of error when estimating inflation increases when lots of time is involved. Therefore, long-term interest rates are generally higher than short-term interest rates. Similarly, stock market investors are negatively affected when inflation causes businesses to pay more when they borrow, thereby reducing their profits and depressing stock prices. When inflation is at 5 percent annually, a dollar of profit that a company will earn a year from now will be worth only 95 cents in today’s prices. If instead inflation were only 2 percent, that dollar would be worth 98 cents today. Such differences add up to significant amounts over many years. Throughout your financial life, you will want to factor the impact of inflation into your financial decisions in an effort to reduce its negative effects.

In summary, to assess the economic outlook for the United States, watch these indicators: (1) GDP and jobs, including unemployment rate changes; (2) procyclic items like inflation and interest rates; (3) countercyclic items like unemployment and gold prices; (4) leading indicators like the consumer confidence index, LEI, and the stock market; (5) interest rates; and (6) the federal funds rate.

DO IT IN CLASS

DID YOU KNOW

Bias Toward Thinking Things Will Continue as They Have

People engaged in the understanding personal finance have a bias toward certain behaviors that can be harmful, such as a tendency toward thinking things will go on as they have recently. During a rising stock market people often will think that things will continue as they have for many more months. What to do? Watch for economic indicators that suggest that the economy and the stock market are reaching a peak and sell stocks that are likely to decline as the economy eventually slows.

CONCEPT CHECK 1.2

1. Summarize the phases of the business cycle.

2. Describe two statistics that help predict the future direction of the economy.

3. Give an example of how inflation affects income and consumption.

1.3 THINK LIKE AN ECONOMIST WHEN MAKING FINANCIAL DECISIONS

Understanding and applying basic economic principles will affect your financial success. The most important of these are opportunity costs, marginal utility and costs, and marginal income tax rate.

LEARNING OBJECTIVE 3

Apply basic economic principles when making financial decisions.

1.3a Consider Opportunity Costs When Making Decisions

The opportunity cost of a decision is the value of the next best alternative that must be forgone. A simple example of opportunity costs in personal finance is spending money on current living expenses, which, of course, reduces the amount you can save and invest and the opportunity to earn interest and dividends. Also, buying on credit results in monthly payments later, which reduces the opportunity to make desired purchases in the future. It is not just the payments and interest that is the cost of credit but other uses of those funds. If opportunity costs are underestimated, then decisions will be based on faulty information, and judgments may prove wrong. Properly valuing opportunity costs of alternatives represents a key step in rational decision making.

opportunity cost The opportunity cost of any decision is the value of the next best alternative that must be forgone.

Using the concept of opportunity costs in your thinking allows you to address the personal consequences of choices because every decision inevitably involves trade-offs. A trade-off is giving up one thing for another. For example, it is wise to give up some current spending in order to enjoy a financially comfortable future. For example, suppose that instead of reading this book you could have gone to a movie or watched television, but mainly you wanted to sleep. The lost benefit of reading—the next best alternative—is the opportunity cost when you choose to sleep. Similarly, keeping the money in a savings account has the opportunity cost of the higher return on investment that a stock market mutual fund might pay. This opportunity to earn a higher rate of return is a primary opportunity cost when making low-risk investment decisions. Other challenging opportunity cost decisions are renting versus buying housing, buying a new or used car, working or borrowing to pay for college, and starting early or late to save and invest for retirement.

trade-off Giving up one thing for another.

FINANCIAL POWER POINT

Save $4.66 for Every $1 Not Saved Earlier

If you want to retire at age 65, you will have to save about $4.66 beginning at age 42 to make up for every dollar you did not save at age 22.

1.3b Identify Marginal Utility and Costs in Your Decision Making

Utility is the ability of a good or service to satisfy a human want. A key task in personal finance is to determine how much utility you will gain from a particular decision. For example, if you decide to spend $90 on a ticket to a concert, you might begin by thinking about what you might gain from the expenditure. Perhaps you’ll enjoy a nice evening, good music, and so on.

Marginal utility is the extra satisfaction derived from having one more incremental unit of a product or service. Marginal cost is the additional (marginal) cost of one more incremental unit of some item. When known, this cost can be compared with the marginal utility received. Thinking about marginal utility and marginal cost can help in decision making because it reminds us to compare only the most important variables. It requires that we examine what we will really gain if we also experience a certain extra cost.

marginal utility The extra satisfaction derived from gaining one more incremental unit of a product or service.

marginal cost The additional (marginal) cost of one more incremental unit of some item.

To illustrate this idea, assume that you will consider spending $150 instead of $90 (an additional $60) for a ground floor seat at the concert. What marginal utility will you gain from that decision? Perhaps it is the ability to see and hear more or the satisfaction of having one of the best seats in the house. You would then ask yourself whether those extra benefits are worth 60 extra dollars. In practice, people are inclined to seek additional utility as long as the marginal utility exceeds the marginal cost.

In another example, imagine that two new automobiles are available on a dealership lot in Ferndale, Michigan, where chemical engineer Pamela Hicks is trying to make a purchase decision. The first, with a sticker price of $29,100, has a moderate number of options; the second, with a sticker price of $32,800, has numerous options. Marginal analysis suggests that Pamela does not need to consider all of the options when comparing the vehicles. Instead, the concept of marginal cost says to compare the benefits of the additional options with the additional costs—$3700 in this instance ($32,800 − $29,100). Pamela needs to decide if the additional options are worth $3700.

1.3c Factor Your Marginal Income Tax Rate When Making Financial Decisions

Financial decisions often have an impact on the income taxes one must pay. Of particular importance is your marginal tax rate , which is the tax rate at which your last dollar earned (not all your income) is taxed. As income rises, taxpayers pay progressively higher marginal income tax rates. Financially successful people often pay U.S. federal income taxes at the 25 percent, or higher, marginal tax rate on the top segment of their income. For example, if Juanita Martinez, an unmarried office manager working in Atlanta, Georgia, has a taxable income of $66,000 and receives a $1000 bonus from her employer, she has to pay an extra $250 in taxes on the bonus income ($1000 × 0.25 = $250). Juanita also has to pay state federal income taxes of 6 percent, or $60 ($1000 × 0.06 = $60), local income taxes of 2 percent and Social Security and Medicare taxes of 7.65 percent, or $76.50 ($1000 × 0.0765 = $76.50). Therefore, Juanita pays an effective marginal tax rate of just over 40 percent (25% + 6% + 2% + 7.65% = 40.65%), or $406.50, on the extra $1000 of earned income.

marginal tax rate The tax rate at which your last dollar earned is taxed.

tax-exempt income Income that is totally and permanently free of taxes.

The Very Best Kind of Income Is Tax-Exempt Income The best kind of income, as this discussion implies, is tax-exempt income , which is income that is totally and permanently free of taxes. People who pay high marginal tax rates often seek out tax-exempt investments, such as buying bonds issued by various agencies of states and municipalities. For example, Serena Miller, a married chiropractor with two children from Prescott, Arizona, currently earns $250 per year on $5000 in stocks and pays $62.50 in federal income tax on that income at her 25 percent marginal tax rate ($250 × 0.25). Alternatively, a tax-exempt $5000 state bond paying 4 percent will provide Serena with a better after-tax return, $200.00 instead of $187.50.

Figure 1-4 Tax-Sheltered Returns Are Greater Than Taxable Returns In the illustration, the annual return is 8 percent and the annual contribution is $2000.

The Second Best Kind of Income Is Tax-Sheltered Income The second best kind of income for individuals is tax-sheltered (or tax-deferred) income —that is, income that is exempt from income taxes in the current year but that will be subject to taxation in a later tax year. Figure 1-4 shows that tax-sheltered returns on savings and investments provide much greater returns than returns on which income taxes have to be paid because more money remains available to be invested. In addition, tax-sheltered funds grow more rapidly because compounding (the subject of the next section in this chapter) is enhanced when larger dollar amounts continue to grow especially during the latter years of an investment.

tax-sheltered (or tax-deferred) income Income exempt from income taxes in the current year but that will be subject to taxation in a later tax year.

CONCEPT CHECK 1.3

1. Define opportunity cost and give an example of how opportunity costs might affect your financial decision making.

2. Explain and give an example of how marginal analysis makes some financial decisions easier.

3. Describe and give an example of how income taxes can affect financial decision making.

1.4 PERFORM TIME VALUE OF MONEY CALCULATIONS

A dollar in your pocket today is worth more than a dollar to be received five years from now. Why? Time is money.

LEARNING OBJECTIVE 4

Perform time value of money calculations in personal financial decision making.

The time value of money (TVM) is perhaps the single most important concept in personal finance. TVM is the cost of money that is borrowed or lent, and it commonly referred to as interest. TMV adjusts for the fact that dollars to be received or paid out in the future are not equivalent to those received or paid out today. It is easy to understand that a dollar received today is worth more than a dollar received five years from now because today’s dollar can be saved or invested and earn some kind of return, such as interest, so that in five years you expect it to be worth more than a dollar. The time value of money involves two components: future value and present value.

time value of money A method by which one can compare cash flows across time, either as what a future cash flow is worth today (present value) or what an investment made today will be worth in the future (future value). Also, the cost of money that is borrowed or lent; it is commonly referred to as interest and adjusts for the fact that dollars to be received or paid out in the future are not equivalent to those received or paid out today.

1.4a There Are Only Two Common Questions About Money

To illustrate the time value of money, two questions in personal finance are commonly asked:

1. What will an investment (or a series of investments) be worth after a period of time? This question asks for a future value, which is referred to as compounding.

2. How much has to be put away today (or as a series of investments) to provide some dollar amount in the future? This question asks for a present value.

As you can see from these two questions, comparisons between time periods cannot be made without making adjustments to money values. Accordingly, time value of money calculations compare future and present values by taking into account the interest rate (or investment rate of return) and the time period involved.

FINANCIAL POWER POINT

To Succeed Financially, Do What Your Grandparents Did

To succeed in life financially, people today can do what their grandparents did. This includes a willingness to postpone gratification, invest for the future, work harder than the next person, and hold your kids to the highest expectations.

Simple Interest The calculation of interest involves (1) the dollar amount, called the principal , (2) the rate of interest earned on the principal, and (3) the amount of time the principal is invested. One way of calculating interest is called simple interest and is illustrated by the simple interest formula

principal The original amount invested.

If someone saved or invested $1000 at 8 percent for four years, he would receive $320 in interest ($1000 × 0.08 × 4) over the four years.

Compounding Is the Basis of All Time Value of Money Considerations But something is missing in the simple interest calculation. The simple interest formula assumes that the interest is withdrawn each year and only the $1000 stays on deposit for the entire four years, and thus interest is not added to the principal. Most people do not invest this way. Instead, they leave the interest earned in the account so that it will earn additional interest. This earning of interest on interest is referred to as compound interest . It arises when interest is added to the principal, so that from that moment on the interest that has been added also itself earns interest. This addition of interest to the principal is called compounding . The effect of compounding depends on the frequency with which interest is paid and the periodic interest rate that is applied. Compound interest is always assumed in time value of money calculations.

compound interest Compound interest is earning of interest on interest and arises when interest is added to the principal so that, from that moment on, the interest that has been added also earns interest.

compounding The addition of interest to principal; the effect of compounding depends on the frequency with which interest is compounded and the periodic interest rate that is applied.

Compounding is the best way to build investment values over time. Because of compounding, money grows much faster when the income from an investment is left in the account. In fact, the deposit of $1000 in our example would grow to $4,661 after 20 years (the calculation is described in the following paragraph). Many of the techniques for building wealth that we describe in this book are based on compounding. The way to build wealth is to make money on your money, not simply to put money away. Yes, you need to put money away first, but compounding over time is what really builds wealth.

Compounding serves as the basis of all time value of money considerations. To see how this works, let us look again at our example in which $1000 is invested at 8 percent for four years. Here is how the amount invested (or principal) would grow using compounding:

Due to the effects of compounding, this investor would have earned an additional $40.49 ($360.49 − $320). While this amount might not seem like much, realize that a $1000 investment for a longer period—say, 40 years—earning 8 percent interest would grow to $21,724.52, providing $20,724.52 in interest over that time period. Simple interest would have resulted in only $3200 in interest ($1000 × 0.08 × 40). The benefit of compounding over that time period is an additional $17,524.52 in interest ($20,724.52 − $3200).

The results are even more dramatic if $1000 is invested at the end of each year for 40 years. The total at the end of 40 years would be $259,056, with $219,056 representing the interest on the invested funds. This illustration suggests one of the cardinal rules of personal financial planning: Getting rich is not a function of investing a lot of money. It is the result of investing regularly for long periods of time. The greatest investment strategy of all is compounding. Only through compounding will you attain the serious growth of your wealth over time.

1.4b Calculating Future Values

Future value (FV) is the valuation of an asset projected to the end of a particular time period in the future. You can calculate the future value of a lump sum or the future value of a series of deposits.

future value The valuation of an asset projected to the end of a particular time period in the future.

Future Value of a Lump Sum Equation (1.4) can be used to calculate the future value of a lump sum:

where i represents the interest rate and n represents the number of time periods. Applying this formula to our earlier example of investing $1000 at 8 percent for four years, we obtain

or

While mathematically correct, these calculations can be cumbersome when using long time periods. Table 1-1 provides a quick and easy way to determine the future dollar value of an investment. For the preceding example, use the table in the following manner: Go across the top row to the 8 percent column. Read down the 8 percent column to the row for four years to locate the factor 1.3605 (at the intersection of the dark brown column and row). Multiply that factor by the present value of the cash asset ($1000) to arrive at the future value ($1360.50).

Appendix A.1 provides an even more complete table for calculating the future value of lump-sum amounts. Figure 1-5 demonstrates the importance of higher yields and longer time horizons by showing the effects of various compounded returns on a $10,000 investment. The $10,000 will grow to $57,435 in 30 years with an interest rate of 6 percent. Compounding $10,000 at 10 percent yields $174,494 over the same time period; at 14 percent, it yields a whopping $509,502! For practice you might want to confirm these results using Appendix A.1.

DO IT IN CLASS

Table 1-1 Future Value of $1 After a Given Number of Periods

Figure 1-5 The Importance of Higher Yields and More Time (Future Value of a Single Investment of $10,000)

DID YOU KNOW

Money Websites for Understanding Personal Finance

Informative websites for understanding personal finance, including present and future values are:

Bankrate.com ( www.bankrate.com/calculators.aspx )

Bureau of Labor Statistics ( www.bls.gov/ )

CNNMoney ( www.cgi.money.cnn.com/ tools/ )

Department of Labor ( www.dol.gov/ebsa/ )

Federal Reserve Board (www.federalreserve .gov/)

Financial Calculators ( www.fincalc.com/ )

KJE ( www.dinkytown.net/ )

moneychimp ( www.moneychimp.com/calculator/compound_interest_calculator.htm )

USA Today ( www.usatoday.com/money/perfi/calculators/calculator.htm )

Future Value of a Stream of Payments (an Annuity) People often save for long-term goals by putting away a series of payments. Appendix A.3 provides a complete table for calculating the future value of a stream of deposited amounts, referred to as an annuity . You can use it to determine the effects of various compounded returns on a $2000 annual investment made at the end of each year. The $2000 will grow to $91,524 in 20 years (read across the interest rate row in Appendix A.3 to 8 percent and then down the column to 20 years to obtain the factor of 45.762 to multiply by $2000) and to $226,566 in 30 years at an 8 percent rate. Compounding $2000 at 10 percent yields $114,550 in 20 years and $328,988 over 30 years; at 14 percent, it becomes $713,574 after 30 years! As you can see, time builds wealth.

annuity A stream of payments to be received in the future.

1.4c Finding Present Values Is Called Discounting

Present value (or discounted value) is the current value of an asset (or stream of assets) that will be received in the future. Discounting is the process of reducing future values to present values. You can calculate the present value of a lump sum to be received in the future or the present value of a series of payments to be received in the future.

Present Value of a Single Lump Sum The present value of a lump sum is the current worth of an asset to be received in the future. Alternatively, it can be thought of as the amount you would need to set aside today at a given rate of interest for a given time period so as to have some desired amount in the future. Suppose you want to have $20,000 for the down payment on a new home in ten years. What would you need to set aside today to reach this goal if you could invest your money and receive a 7 percent return? Using Appendix A.2 you could look across the interest rate rows to 7 percent and then down to ten years to obtain the factor of 0.5083. Multiplying $20,000 by this factor reveals that $10,166 set aside today would allow you to reach your goal.

A simple formula for figuring the number of years it takes to double the principal using compound interest is the Rule of 72. Simply divide the interest rate that the money will earn into the number 72.

Present Value of a Stream of Payments (an Annuity) The present value of an annuity is the current worth of a stream of payments to be received in the future. Alternatively, it can be thought of as the amount you would need to set aside today at a given rate of interest for a given time period so as to receive that stream of payments. Suppose you want to have $30,000 per year for 20 years during your retirement. What amount would you need to have invested at retirement to reach this goal if you could invest your money and receive a 7 percent return? Using Appendix A.4 you could look across the interest rate rows to 7 percent and then down to 20 years to obtain the factor of 10.5940. Multiplying $30,000 by this factor reveals that $317,820 (10.5940 × $30,000) set aside at retirement would fund this stream of payments. Note the beauty of compound interest in this result. It takes only $317,820−not $600,000−to fund a $30,000 per year retirement for 20 years if you can earn 7 percent on your financial nest egg. *

CONCEPT CHECK 1.4

1. Explain the difference between simple interest and compound interest, and describe why that difference is critical.

2. What are the two components used when figuring the time value of money?

3. Use Table 1-1 to calculate the future value of (a) $2000 at 5 percent for four years, (b) $4500 at 9 percent for eight years, and (c) $10,000 at 6 percent for ten years.

1.5 MAKE SMART MONEY DECISIONS AT WORK

Smart decisions about your employee benefits can increase your actual income by 30 percent or more each year. An employee benefit is compensation for employment that does not take the form of wages, salaries, commissions, or other cash payments. Your benefits package might also include paid vacations and sick days, health insurance, a retirement plan, child care, and an educational assistance program.

employee benefit Compensation for employment that does not take the form of wages, salaries, commissions, or other cash payments.

LEARNING OBJECTIVE 5

Make smart decisions about your employee benefits.

1.5a Choosing Tax-Free Cafeteria Plan Benefits

A cafeteria (or flexible benefits) plan is a type of employee benefit plan where employees choose their benefits from a “menu” of both taxable and one or more qualified nontaxable or tax-sheltered benefits, thereby providing a funding mechanism by which employees may pay for some of the benefits they choose on a pretax basis. For example, an employer might offer $4000 annually to each employee to spend on benefits. The plan might offer health insurance, life insurance, sick leave or disability benefits, medical expense reimbursement, vacation days, dependent care, adoption assistance, and orthodontia treatments. Employees choose the benefits they want and can design their own benefits package.

cafeteria plan (flexible benefits plan) A type of employee benefit plan where employees choose their benefits from a “menu” of taxable and tax reducing benefits, thereby providing a funding mechanism by which employees may pay for some of the benefits they choose on a pretax basis.

1.5b Making Decisions About Employer’s Flexible Spending Accounts

Some employee benefits are tax-sheltered. A flexible spending account (FSA) , also called a flexible spending arrangement, is an employer-sponsored account that allows employee-paid expenses related to health and dependent care to be paid with pretax dollars (money income that has not been taxed by the government) rather than after-tax income. Under a typical FSA, the employee agrees to have a certain amount deducted from each paycheck that is then deposited into a separate account. There are two types of flexible spending accounts; the medical and dental expense FSA and the dependent care FSA. FSA contributions are limited to $2500. Dependent care FSA contributions are limited to $5000 per year. As eligible expenses are incurred, the employee requests and receives reimbursements from the account.

flexible spending account (FSA) An employer-sponsored account that allows employee-paid expenses for medical or dependent care to be paid with an employee’s pretax dollars rather than after-tax income.

pretax dollars Money income that has not been taxed by the government.

Because many workers pay combined effective marginal income tax rates (discussed earlier) of about 40 percent, that same percentage can be saved by not giving it to the government in taxes. The worker who contributes $5000, for example, to a flexible spending account (FSA) saves approximately $2000 ($5000 × 0.40) in taxes, further reducing his or her overall expenses.

Funds in a dependent care FSA account may be used to pay for the care of a dependent younger than age 13 or the care of another dependent who is physically or mentally incapable of caring for himself or herself and who resides in the taxpayer’s home. Funds in a medical care FSA account may be used to pay for qualified, unreimbursed out-of-pocket expenses for health care, but they may not be used for over-the-counter medicines unless specifically prescribed by a doctor.

Before enrolling in an FSA, you need to estimate your expenses carefully so that the amount in the FSA does not exceed anticipated expenses. According to Internal Revenue Service (IRS) regulations, unused amounts are forfeited and are not returned to the employee—a condition called the “use it or lose it” rule. However, employers may choose to offer a 2½-month grace period during which time you can continue to spend up to $500 of the previous year’s FSA money. Many employers offer debit cards that withdraw money directly from an employee’s FSA. Only about 20 percent of eligible employees participate in flexible spending accounts, even though doing so saves money.

DO IT IN CLASS

DID YOU KNOW

A Baker’s Dozen of Good Financial Behaviors

Good financial behaviors to follow include these:

1. Develop a plan for your financial future.

2. Saving regularly and increase savings as income grows.

3. Follow a budget or spending plan to control and/or reduce living expenses.

4. Keep personal debts to a minimum.

5. Pay credit card bills in full each month.

6. Sign up to participate in employer’s retirement plan.

7. Calculate how much money is needed for retirement and then save for it through your employer’s plan and/ or an individual retirement account (IRA).

8. Comparison shop for purchases.

9. Use a credit/budget counselor if debt becomes unmanageable.

10. Contemplate how economic events will affect personal financial decision making.

11. Consult a financial planner when faced with complicated financial questions.

12. Set aside an emergency fund sufficient to live on for three to six months.

13. Contribute to a flexible spending account at work.

1.5c Making Decisions About Employer-Sponsored Health Care Plans

Many employers offer employees a choice of health care plans to assist employees with their health care expenses. The premium for an employee’s individual or family plan could be as high as $10,000 annually depending upon the amount of coverage selected. The premiums for employees are often either paid for entirely or partially by the employer. For example, some employers pay the first $3000 of annual premiums for employee health care coverage and require that employees pay the remainder. Employees usually can make a decision to change health plans once a year as well as when one’s family situation changes, such as getting married.

health care plans An employee benefit designed to pay all or part of the employee’s medical expenses.

Employers often offer multiple options for health care plans. These may include an expensive traditional health plan, perhaps with a high annual premium that offers comprehensive coverage requiring little out-of-pocket health care spending by the employee. Also frequently available is a less expensive high-deductible health plan (HDHP) , which has lower premiums and higher deductibles than a traditional health plan. The deductible is the amount paid to cover health care expenses before benefits begin. A policy with perhaps a $3500 premium might require larger out-of-pocket health care spending by the employee.

high-deductible health plan (HDHP) A plan that requires individuals to pay a higher deductible to cover medical expenses before insurance plan payments begin; chosen to save money on premiums.

deductible An initial portion of any loss that must be paid before collecting insurance benefits.

Younger employees, particularly those who are typically healthy, often select high-deductible plans to save on the cost of premiums. For example, if an employer pays only the first $3000 in health care premiums for employees, an employee selecting the high-cost plan described previously has to pay $6000 ($9000 premium — $3000 employer contribution) annually, or $500 a month in premiums. This contrasts with only a $500 total annual premium for employees who select the high-deductible plan ($3500 premium — $3000 employer contribution). The maximum out-of-pocket limit for HDHPs is $6250 for self-only coverage and $12,500 for self-and-family coverage, after which the policy is supposed to pay for all health expenses.

Some employers also offer health savings accounts (HSAs) . This special savings account is intended for people who have a high-deductible health care plan. Employees make tax-deductible contributions to a savings account to be used for eligible expenses. Employers may also contribute. The employee invests HSA funds, and the money in the account grows tax free. Withdrawals are made to pay for medical expenses. The limits on contributions to an HSA are $3300 per year for individuals and $6550 for families. The money in the account remains there even if you don’t spend it within a certain time period.

health savings accounts (HSAs) Special savings account intended for people who have a high-deductible health care plan (with annual deductibles of at least $1000 for individuals and $2000 for families).

1.5d Making Decisions About Participating in Employer Insurance Plans

Life, disability, and long-term care insurance coverages are often available through employers. While the premiums charged for the group of employees for life insurance are rarely as low as those available in the general marketplace, some employers pay for part or all of employees’ premiums. Coverage is typically one or two times the employee’s salary. So, always sign up for free or subsidized life insurance at work. The premiums for disability and long-term care insurance are often less expensive when purchased through one’s employer rather than in the general marketplace. See Chapters 10 , 11 , and 12 to begin to purchase any needed insurance coverage.

1.5e Making Decisions About Participating in Your Employer’s Retirement Plan

More than half of all workers are covered by an employer-sponsored, defined-contribution retirement plan, also called a tax-sheltered retirement plan . These include 401(k) plans and similar 403(b) and 457 plans, as discussed in Chapter 17 , “Retirement and Estate Planning.” Employer-sponsored retirement plans provide four distinct advantages.

tax-sheltered retirement plan Employer-sponsored, defined-contribution retirement plans including 401(k) plans and similar 403(b) and 457 plans.

DID YOU KNOW

Turn Bad Habits into Good Ones

Do You Do This?

Ignore news about the economy

Buy lots of extra features on products

Focus only on take-home pay

Don’t know how much to save for retirement

Have not yet started to invest for retirement

Pay out-of-pocket expenses for health care

Get financial advice from friends

Do This Instead!

Watch business news on cable television

Use marginal costs in buying decisions

Sign up for employer tax-advantaged saving plans

Calculate future values

Begin investing as soon as possible

Use employer’s cafeteria benefits plan for expenses

Seek advice of fee-only financial planner

First Advantage: Tax-Deductible Contributions Tax-sheltered retirement plans provide tremendous tax benefits compared with ordinary savings and investment plans. Because pretax contributions to qualified plans reduce taxable income, the current year’s tax liability is lowered. The money saved in taxes can then be used to partially fund a larger contribution, which creates even greater returns. The 401(k) plan lets the IRS help employees finance their retirement plans because of the income taxes saved.

As Table 1-2 illustrates, you can save substantial sums for retirement with minimal effects on your monthly take-home pay. For example, a married man like Hongbok Lee of Macomb, Illinois, with a monthly taxable income of $4000 paying taxes at the 25 percent marginal tax rate who forgoes some spending and places $500 into a tax-sheltered retirement plan every month reduces monthly take-home pay from $3345 to $2970, or $375—that is certainly not an enormous amount.

The net effect is that it costs Hongbok only $375 to put away that $500 per month into a retirement plan. The immediate “return on investment” equals a fantastic 25 percent ($125 / $500). In essence, the taxpayer puts $375 into his or her retirement plan and the government contributes $125. (Without the plan, the taxpayer would pay the $125 directly to the government.) A taxpayer paying a higher marginal tax rate realizes even greater gains. Because a substantial part of your contributions to a tax-sheltered retirement plan comes from money that you would have paid in income taxes, it costs you less to save more. In addition, the Social Security Administration credits Hongbok with an earned income of $4000 a month rather than $3500.

Table 1-2 It Costs Only $375 a Month (or $4500) to Save $6000 a Year for Retirement

Second Advantage: Employer’s Matching Contributions To retain employees and encourage saving for retirement, many employers also offer employer-paid matching contributions in addition to amounts contributed by the employee. Employers may match all or part of their employees’ contributions. An employee who saves $250 might receive an additional $250 a month from his/ her employer. That’s a 100 percent return on the employee’s $250! More typically, employer’s match fifty percent of an employee’s contributions up to a certain maximum—still, a nice 50 percent return.

Third Advantage: Employer’s Contributions Are Not Income You will pay income taxes on any employer’s contributions to your 401(k) retirement plan only when you withdraw from the account. That may not be until you retire and perhaps are in a lower tax bracket than you were in when the contributions were made.

Careful planning can result in a much more comfortable life when you retire.