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To quote John Lennon, Life is what happens to you while you’re busy making other plans. As a business owner, you know the importance of having a solid financial plan so you can manage cash flow and have the necessary reserves for unexpected expenses or market downturns. It is even more critical that you have a plan in place for your own financial success, not only for someday when you retire, but along the way when “life happens”, such as the loss of your business, care for aging parents or the end of your marriage.
This article will point out key areas you need to consider and incorporate into your personal financial plan, including reducing debt, creating cash reserves, saving for retirement, selecting an investment advisor, managing risk and estate planning.
Let’s get started.
Step one
Tackle expensive debt. Consider your assets and their potential earnings and compare them to your liabilities. Saving for the future is critical, but if you have a car loan or credit card debt with a rate higher than 5 or 6%, pay it off. Rather than investing the funds and bearing market risk plus paying taxes on the earnings, you receive a guaranteed rate of return when you pay down debt because the expense is gone. That’s even before considering the emotional reward of lowering your debt burden.
Step Two
Cash is king not only in your business but in your personal financial situation. After you have initiated a plan to pay down high-cost debt, begin building up a cash reserve that will cover all of your living expenses for 3 months. Be realistic about your lifestyle, because it is unlikely you would pull your child out of private school mid-year or could quickly sell your second home if business income were suddenly reduced. Consider obtaining a second line of credit on your home with a reasonable limit like $25,000 - $100,000. Rates are often tied to Prime (currently 3.25%) and it is typically very inexpensive to set up and maintain a $0 balance. Think of the peace of mind this would bring. Knowing you have access to low-cost capital beyond your 3 months reserves can help you avoid building up credit card debt if unexpected expenses arise or your income is suddenly reduced.
Step Three
It may sound selfish, but make sure you are saving for your retirement before your children’s college education. Your children have opportunities for scholarships and financial aid for college, but these aren’t available for retirement! Talk with your accountant or financial advisor about the best retirement plan to use given your age, income level, and business structure. Take advantage of every opportunity to put money into retirement plans, particularly if there is an employer match. The reason why is the Rule of 72.
Marginal income tax rates are set to go even higher in 2013, so it’s powerful to compound money tax-deferred. Here’s an example: If the average annual rate of return for a stock and bond portfolio was 8%, the Rule of 72 would estimate that your money would double in about 9 years. If, instead, you are paying 35%-40% in income taxes every year on the earnings, your average rate of return could be reduced to 6% after-tax or even less. That would increase the time it takes to double your money to 12 years. Assuming the same portfolio allocation, the simple decision to save dollars inside a tax-deferred account can effectively increase your end result.
Step Four
Unless your financial plan includes winning the lottery right before you retire, keep on saving after maxing out your retirement contributions. A reasonable rule of thumb is that you can sustainably withdraw 3% annually from your portfolio at age 65 for the remainder of your life. This is where an investment advisor is particularly valuable to provide guidance. Unless you are in the industry already, this is not an area to dabble in.
Step Five
You can do everything right in terms of savings and then risk your family’s financial security due to lack of proper insurance coverage. Do not underestimate the value of having top-notch insurance professionals in the areas of property/casualty insurance, disability, long-term care and life insurance. Here are several key considerations:
· Match the total of the underlying liability limits on your homeowners and auto policies plus excess liability policy coverage to your net worth. This insurance is relatively inexpensive to ensure that you cannot lose everything you have worked for due to a lawsuit.
· Think of disability and life insurance as income replacement coverage. In the case of disability coverage, benefits could be up to 66% of your gross earnings. An experienced agent can help walk you through the various decisions to be made before purchasing a policy - ranging from elimination period to definition of disability.
Life insurance proceeds create a larger asset base, increasing potential portfolio income which your family can use to provide for lifestyle and education needs. It can also be invaluable if your business has significant value yet is illiquid or has ongoing obligations that wouldn’t immediately terminate on your death. The death benefit can provide liquidity so your family has the freedom of time to most effectively sell your company and cover ongoing business expenses in the interim.
· Long-term care is an important consideration as well in your retirement planning as it provides asset protection. The insurance coverage pays for care needed if you are unable to perform two or more activities of daily living (bathing, toileting, eating, transferring, driving, continence). Given the increase in anticipated life spans and the national average for long-term care exceeding $75,000 per year, your assets could be depleted quickly without the benefit of insurance.
Step Six
Execute and maintain current estate documents that include a will (or revocable trust), durable power of attorney, and a directive to physician. Make sure that your assets are titled in keeping with your estate plan. It is not uncommon to have a will state how your assets should pass but have all brokerage accounts titled Joint Tenants with Right of Survivorship and then pass outside of probate.
Likewise, make sure your beneficiary designations for retirement plans and life insurance match your wishes and aren’t left to your estate, thus causing them to be subject to probate and potentially adverse income tax consequences. Avoid needless legal and court costs by appointing a family member or friend as your attorney-in-fact for health care and financial decisions. Also, sign a living will or directive to physician so your end-of-life decisions are clear.
In Summary
There is an old saying that cobbler’s children have no shoes. Don’t put yourself and your family at risk and have everything in place for your business’ success yet have no emergency reserves, retirement plan, adequate insurance protection or a current estate plan. Use the outlined action plan to begin tackling these important issues and set dates for completion, then set up an annual review, so that when “life happens”, you aren’t caught barefoot.
First Steps to Being in Charge of your Financial Life
· Pay off consumer debt
· Build 3 months reserve for living expenses
· Maximize annual contribution to retirement plan for yourself and your spouse, if applicable
· Meet with financial advisor and determine long-term savings needed to meet your retirement objectives
· Save for your children’s education
Risk management
· Maintain excess liability coverage in line with your net worth
· Purchase disability insurance equal to the lesser of 66% of your annual earned income or your after-tax lifestyle
· If your family is dependent upon your earning power, acquire a life insurance policy that will effectively replace that income stream. The life insurance industry recommendations are as follows:
Ages Multiple of earned income
20-30: 23–27
31-40 20-23
41-45 16-19
46-50 13-16
51-55 10-12
56-60 8-10
61-65 6-8
· Consider long-term care insurance to protect assets as part of retirement plan
Estate planning
· Work with an attorney to create or update your will or revocable trust, durable power of attorney (both for health care and financial decisions) and directive to physician
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