Too few Americans understand personal finance fundamentals.
If only money came with instructions. If it did, the route toward wealth would be clear and direct. Unfortunately, many people have inadequate financial knowledge, and for them, the path is more obscure.
Are most people clueless about financial matters? That depends on what gauge you want to use to measure financial knowledge. The U.S. ranked fourteenth in Standard & Poor’s 2015 Global Financial Literacy Study, with just 57% of the country’s population estimated as financially literate.1
Obviously, the other 43% of Americans have some degree of financial understanding – but it is mixed with a degree of incomprehension. Witness some examples:
*A recent LendU survey found that nearly half of college students carrying student loans thought those debts would eventually be forgiven if left unpaid.*This year, Fidelity Investments asked Americans the following question in a multiple-choice quiz: “If you were able to set aside $50 each month for retirement, how much could that end up becoming 25 years from now, including interest, if it grew at the historical stock market average?” The correct answer was $40,000, but just 16% of respondents got it right. Another 27% guessed $15,000 (i.e., 50 x 12 x 25, as if interest was not a factor).*Only 42% of those quizzed by Fidelity knew that withdrawing 4-5% a year from retirement savings is commonly recommended. Fifteen percent of those older than 55 thought they would be “safe” withdrawing 10-12% per year.*The S&P 500 has returned positively in 30 of the last 35 years. Just 8% of those answering Fidelity’s quiz guessed this.2,3
Apart from these examples, consider another one at the macro level. According to the latest National Financial Capability Study from FINRA (the Financial Industry Regulatory Authority), only about a third of Americans younger than 40 understand the basic financial concepts of compounding, inflation, and risk diversification.1
Statistics aside, think about how a lack of financial acumen hurts people’s chances to build or protect wealth. How about the employee who skips retirement plan enrollment at work, mistakenly thinking that a tax-advantaged retirement account is the same as a bank account? Or the small business owner puzzled by cash flow and profit-and-loss statements? Or the young borrower who fails to grasp the long-run consequences of only making interest payments on a credit card or loan?
Financial professionals continually educate themselves. They stay on top of economic, tax law, and market developments. Investors should as well. Ten or twenty years from now, you may find yourself in an entirely different place financially – who knows? The economy, the Wall Street climate, and even the investment opportunities before you could all differ from what you see today. If your financial knowledge is ten or twenty years out of date, you risk being at a disadvantage.
Financial literacy is not about prevention, but instead about empowerment. The more you understand about personal finance, the more potential you give yourself to make smart money decisions.
This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note - investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.
Citations.1 - marketwatch.com/story/should-colleges-require-a-financial-literacy-class-2017-04-03/ [4/3/17]2 - investopedia.com/news/3-ways-improve-financial-literacy/ [4/21/17]3 - marketwatch.com/story/most-americans-failed-this-eight-question-retirement-quiz-2017-03-23 [3/23/17]
They are low, unless you show the I.R.S. some conspicuous “red flags” on your return.
Fewer than 1% of Americans have their federal taxes audited. The percentage has declined recently due to Internal Revenue Service budget cuts. In 2016, just 0.7% of individual returns were audited (1 of every 143). That compares to 1.1% of individual returns in 2010.1,2
The rich are more likely to be audited – and so are the poor. After all, an audit of a wealthy taxpayer could result in a “big score” for the I.R.S., and the agency simply cannot dismiss returns from low-income taxpayers that claim implausibly large credits and deductions.
Data compiled by the non-profit Tax Foundation shows that in 2015, just 0.47% of Americans with income of $50,000-75,000 were audited. Only 0.49% of taxpayers who made between $75,000-100,000 faced I.R.S. reviews. The percentage rose to 8.42% for taxpayers who earned $1-5 million. People with incomes of $1-25,000 faced a 1.01% chance of an audit; for those who declared no income at all, the chance was 3.78%.2
What “red flags” could prompt the I.R.S. to scrutinize your return? Abnormally large deductions may give the I.R.S. pause. As an example, suppose that you earned $95,000 in 2016 while claiming a $14,000 charitable deduction. Forbes estimates that the average charitable deduction for such a taxpayer last year was $3,529.3
Sometimes, the type of deduction arouses suspicion. Taking the Earned Income Tax Credit (EITC) without a penny of adjusted gross income, for example. Or, claiming a business expense for a service or good that seems irrelevant to your line of work. A home office deduction may be ruled specious if the “office” amounts to a room in your house that serves other purposes. Incongruous 1099 income can also trigger a review – did a brokerage disclose a big capital gain on your investment account to the I.R.S. that you did not?4
Self-employment can increase your audit potential. In 2015, for example, taxpayers who filed a Schedule C listing business income of $25,000-100,000 had a 2.4% chance of being audited.2
Some taxpayers illegitimately deduct hobby expenses and try to report them on Schedule C as business losses. A few years of this can wave a red flag. Is there a profit motive or profit expectation central to the activity, or is it simply a pastime offering an occasional chance for financial gain?
If you are retired, does your audit risk drop? Not necessarily. You may not be a high earner, but there is still the possibility that you could erroneously claim deductions and credits. If you claim large medical expenses, that might draw extra attention from the I.R.S. – but if you have proper documentation to back up your claims, you can be confident about them.
The I.R.S. does watch Required Minimum Distributions (RMDs) closely. Failure to take an RMD will draw scrutiny. Retirees who neglect to withdraw required amounts from IRAs and employer-sponsored retirement plans can be subject to a penalty equal to 50% of the amount not withdrawn on time.1
The fastest way to invite an audit might be to file a paper return. TurboTax says that the error rate on hard copy returns is about 21%. For electronically filed returns, it falls to 0.5%. So, if you still drop your 1040 form off at the post office each year, you may want to try e-filing in the future.4
Citations.1 - kiplinger.com/slideshow/retirement/T056-S011-9-irs-audit-red-flags-for-retirees/index.html [3/17]2 - fool.com/retirement/2017/02/06/here-are-the-odds-of-an-irs-audit.aspx [2/6/17]3 - forbes.com/sites/baldwin/2017/01/23/tax-guide-deductions-and-audit-risk/ [1/23/17]4 - fool.com/retirement/2016/12/19/9-tax-audit-red-flags-for-the-irs.aspx [12/19/16]
Too many people make these common errors.
Many affluent professionals and business owners put estate planning on hold. Only the courts and lawyers stand to benefit from their procrastination. While inaction is the biggest estate planning error, several other major mistakes can occur. The following blunders can lead to major problems.
Failing to revise an estate plan after a spouse or child dies. This is truly a devastating event, and the grief that follows may be so deep and prolonged that attention may not be paid to this. A death in the family commonly requires a change in the terms of how family assets will be distributed. Without an update, questions (and squabbles) may emerge later.
Going years without updating beneficiaries. Beneficiary designations on qualified retirement plans and life insurance policies usually override bequests made in wills or trusts. Many people never review beneficiary designations over time, and the estate planning consequences of this inattention can be serious. For example, a woman can leave an IRA to her granddaughter in a will, but if her ex-husband is listed as the primary beneficiary of that IRA, those IRA assets will go to him per the beneficiary form. Beneficiary designations have an advantage – they allow assets to transfer to heirs without going through probate. If beneficiary designations are outdated, that advantage matters little.1,2
Thinking of a will as a shield against probate. Having a will in place does not automatically prevent assets from being probated. A living trust is designed to provide that kind of protection for assets; a will is not. An individual can clearly express “who gets what” in a will, yet end up having the courts determine the distribution of his or her assets.2
Supposing minor heirs will handle money well when they become young adults. There are multi-millionaires who go no further than a will when it comes to estate planning. When a will is the only estate planning tool directing the transfer of assets at death, assets can transfer to heirs aged 18 or older in many states without prohibitions. Imagine an 18-year-old inheriting several million dollars in liquid or illiquid assets. How many 18-year-olds (or 25-year-olds, for that matter) have the skill set to manage that kind of inheritance? If a trust exists and a trustee can control the distribution of assets to heirs, then situations such as these may be averted. A well-written trust may also help to prevent arguments among young heirs about who was meant to receive this or that asset.3
Too many people do too little estate planning. Avoid joining their ranks, and plan thoroughly to avoid these all-too-frequent mistakes.
Citations.1 - thebalance.com/why-beneficiary-designations-override-your-will-2388824 [10/8/16]2 - fool.com/retirement/2017/03/03/3-ways-to-keep-your-estate-out-of-probate.aspx [3/3/17]3 - info.legalzoom.com/legal-age-inherit-21002.html [3/16/17]
Will it apply to your retirement savings distribution?
If you receive a distribution from your IRA or workplace retirement plan, what will you do with it? You will probably want to arrange an IRA rollover – a common and useful financial move designed to take these invested assets from one retirement account to another, without tax consequences. The I.R.S. may give you just 60 days to do it, however.
The clock starts ticking on the day you receive the distribution. If assets from your employee retirement plan account or your IRA are paid directly to you, you have 60 calendar days to transfer those funds into an IRA or workplace retirement plan. If you fail to do that, the I.R.S. will characterize the entire distribution as taxable income. (It may also tack on a 10% early withdrawal penalty if you take possession of such funds before age 59½.)1
Your goal is to make this indirect rollover by the deadline. It is called an indirect rollover because its mechanics can be a bit involved. If the assets are coming out of an employee retirement plan, your employer may withhold 20% of them in accordance with tax laws. Unfortunately, you do not have the option of depositing only 80% of the distribution into an IRA or another employee retirement plan – you must deposit 100% of it by the deadline. You have to come up with the remaining 20%, yourself, from your own savings. The withheld 20% should be returned to you at tax time if the rollover completes smoothly.2
Can you make multiple IRA rollovers using funds from a single IRA? You can, but the I.R.S. says the rollovers must occur at least 12 months apart. Additionally, the I.R.S. prohibits you from making a rollover out of the “new” IRA that receives the transferred assets for a year following that transfer.1
This 12-month limit does not apply to every kind of retirement plan rollover. Trustee-to-trustee transfers, where the investment company (acting as custodian of your IRA or retirement plan account) simply sends a check for the assets to the brokerage firm that will eventually receive them, are exempt from the 60-day deadline. So are rollovers between workplace retirement plans, IRA-to-plan rollovers, and plan-to-IRA rollovers. If you are converting a traditional IRA to a Roth IRA, the 60-day rule is also irrelevant.1,2
Some retirement savers simply opt for a trustee-to-trustee transfer – a direct rollover – rather than an indirect one. A direct rollover of retirement assets is routine, and it can be coordinated with the help of a financial professional. If you do prefer to perform an indirect rollover on your own, be mindful of the 60-day rule and the potential ramifications of missing the deadline.
Citations.1 - irs.gov/retirement-plans/plan-participant-employee/rollovers-of-retirement-plan-and-ira-distributions [2/8/17]2 - fool.com/retirement/2017/03/08/what-to-do-with-your-old-401k-when-switching-jobs.aspx [3/8/17]
Where do things proceed from that point?
Every day, people die intestate. In legalese, that means without a will. This opens the door for the courts to decide what happens with their estates.
When no valid will exists, state intestacy laws dictate how assets are distributed. These laws divide an estate evenly (or equitably) among heirs. Any assets held in joint tenancy go to the joint owner. Assets held in a trust transfer to the trust beneficiaries (with spouses getting a share of those assets in some states). Community property goes to a spouse or partner in community property states.1
Simple, right? Unfortunately, the way assets transfer under these laws may not correspond to the wishes of the deceased person. Did the decedent want some of his or her estate to go to a charity or a person close to them? These laws will not allow that. State law will also decide who the executor of the estate is, since the decedent never named one.2
If the deceased person designated beneficiaries for his or her retirement accounts and life insurance policy, those retirement accounts and insurance proceeds should transfer to those beneficiaries without dispute, even when no will exists. When life insurance policies and retirement accounts lack designated beneficiaries, then those assets are lumped into the decedent’s estate and subject to intestacy laws.2
Most people have specific ideas about who should inherit what from their estates. To articulate those ideas, they should write a will – or better yet, they should draft one with the help of an attorney. Anyone who cares about the destiny of his or her wealth should take this basic estate planning step.
For a last will & testament to be valid, it must meet three important tests. It must be created by a person of sound mind. It must express that person’s free will – that is, it cannot be written or drafted under coercion or duress. Lastly, it must be signed and dated in the presence of two or more unrelated people who stand to inherit nothing from that person’s estate.1
Many wills are signed in the presence of notaries; although, a will does not have to be notarized to be legally valid. Some wills are self-proving – they have an attached, notarized affidavit, which acknowledges that all three tests noted in the preceding paragraph have been met. When this affidavit accompanies a will, there is no need to track down the parties who witnessed the signing and dating of the document years before.1
A last will and testament should be formatted and printed using a computer and printer; at the very least, it should be typed. Handwritten wills may not pass muster in some probate courts.1
When an individual dies intestate, the future of his or her estate is largely up to the courts. A basic, valid will stating his or her wishes may prevent that fate.
Citations.1 - legalzoom.com/knowledge/last-will/topic/wills-intestate [3/20/17]2 - money.cnn.com/2016/04/28/pf/dying-without-a-will-prince/ [4/28/16
What are the keys in planning to grow wealthy together?
When you marry or simply share a household with someone, your financial life changes – and your approach to managing your money may change as well. To succeed as a couple, you may also have to succeed financially. The good news is that is usually not so difficult.
At some point, you will have to ask yourselves some money questions – questions that pertain not only to your shared finances, but also to your individual finances. Waiting too long to ask (or answer) those questions might carry an emotional price. In the 2016 TD Bank Love & Money survey of 1,902 consumers who said they were in relationships, 42% of the respondents who described themselves as “unhappy” cited their number one financial error as “waiting too long” to discuss money matters with their significant other.1
First off, how will you make your money grow? Investing is essential. Simply saving money will help you build an emergency fund, but unless you save an extraordinary amount of cash, your uninvested savings will not fund your retirement.
So, what should you invest in? Should you hold any joint investment accounts or some jointly titled assets? One of you may like to assume more risk than the other; spouses often have different individual investment preferences.
How you invest, together or separately, is less important than your commitment to investing. Some couples focus only on avoiding financial risk – to them, maintaining the status quo and not losing any money equals financial success. They could be setting themselves up for financial failure decades from now by rejecting investing and retirement planning.
An ongoing relationship with a financial professional may enhance your knowledge of the ways in which you could build your wealth and arrange to retire confidently.
How much will you spend & save? Budgeting can help you arrive at your answer. A simple budget, an elaborate budget, any attempt at a budget can prove more informative than none at all. A thorough, line-item budget may seem a little over the top, but what you learn from it may be truly eye-opening.
How often will you check up on your financial progress? When finances affect two people rather than one, credit card statements and bank balances become more important. So do IRA balances, insurance premiums, and investment account yields. Looking in on these details once a month (or at least once a quarter) can keep you both informed, so that neither one of you have misconceptions about household finances or assets. Arguments can start when money misconceptions are upended by reality.
What degree of independence do you want to maintain? Do you want to have separate bank accounts? Separate “fun money” accounts? To what extent do you want to comingle your money? Some spouses need individual financial “space” of their own. There is nothing wrong with this, unless a spouse uses such “space” to hide secrets that will eventually shock the other.
Can you be businesslike about your finances? Spouses who are inattentive or nonchalant about financial matters may encounter more financial trouble than they anticipate. So, watch where your money goes, and think about ways to repeatedly pay yourselves first, rather than your creditors. Set shared short-term, medium-term, and long-term objectives, and strive to attain them.
Communication is key to all this. In the TD Bank survey, nearly 80% of the respondents who indicated they talked about money once per week said that they were happy with their relationship. Follow their lead and plan for your progress together.1
Citations.1 - gobankingrates.com/personal-finance/surprising-ways-money-affects-love-life/ [9/26/16]