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					10    Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition




     DISCUSSION QUESTIONS AND SOLUTIONS

                           1. What is personal financial planning?
                               Personal financial planning is the process of formulating, implementing, and monitoring
                               multifunctional decisions that enable an individual or family to achieve financial goals.
                           2. What does it mean to say that financial success is a relative concept?
                               Financial success means different things to different people because each person compares
                               financial success with the person's own benchmarks or standards. If you had $1,000 and
                               everyone else around you only had $1, you would likely feel financially successful. However,
                               if everyone else around you had $10,000, it is likely you would not feel financially successful.
                           3. How does the financial planning process promote efficient allocation of a client’s
                              resources?
                               Financial planning provides a client with a framework of objective alternatives that identi-
                               fies the opportunity cost associated with each alternative so that the client can make a more
                               informed, more rational choice among alternatives.
                           4. Why do people hire professional financial planners?
                               People hire professional financial planners because they believe that doing so is more effec-
                               tive and efficient than attempting to create and implement a financial plan on their own.
                           5. What does the Financial Planner’s Pyramid of Knowledge identify?
                               The Financial Planner’s Pyramid of Knowledge identifies the skills required of financial
                               planners, the basic tools the financial planner must possess, the core topics in which the
                               planner must be knowledgeable, and the professional responsibilities that apply to financial
                               planning.
                           6. What benefits can a client derive from the process of personal financial planning?
                               ■ It assists in goal identification and prioritization.
                               ■ It provides an objective, rational view of choices and resource allocation.
                               ■ It promotes the future and proactive thinking rather than the past and reactive thinking.
                               ■ It creates a framework for feedback, evaluation, and control.
                               ■ It requires a thorough, systematic analysis of the internal and external environment.
                               ■ It identifies risks and, thus, minimizes their effect through the risk management process.
                               ■ It promotes a positive view of change by viewing it as an opportunity for goal
                                 accomplishment.
                               ■ It provides discipline and formality to financial affairs.
                           7. What concepts must a professional financial planner balance in order to create a
                              successful financial plan?
                               ■ Financial success is a relative concept.
                               ■ There is both subjectivity and objectivity in financial planning.
                               ■ Financial planning is about the allocation of resources.
                               ■ Rational choices are dependent on personal utility curves.
                                        Chapter 1 | Introduction to Personal Financial Planning   11


   ■ Every alternative has consequences and risks.
   ■ Financial planning promotes efficiency by devoting fewer resources to correcting poor
     decisions.
8. Through what activities is the personal financial planner expected to guide the
   client?
   The personal financial planner is expected to guide the client through the six steps of the
   financial planning process:
   1.   Establishing the client-planner relationship
   2.   Gathering client data and determining client goals and expectations
   3.   Determining the client's financial status by analyzing and evaluating general financial
        status, special needs, insurance and risk management, investments, taxation, employee
        benefits, retirement planning, and estate planning
   4.   Developing and presenting the financial plan
   5.   Implementing the financial plan

   6.   Monitoring the financial plan
                                                                                     Chapter 2 | External Environmental Analysis        37




   DISCUSSION QUESTIONS AND SOLUTIONS

                              1. How do the external and internal environments in which financial planning
                                 occurs differ?
                                   The success of a client in financial planning is influenced by both internal and external
                                   environmental influences. Internal environmental forces include a client’s current and pro-
                                   jected financial situation, tolerance for risk, discipline regarding savings and investments,
                                   consumption patterns, and financial goals. The external environment is made up of a variety
                                   of external factors, or subenvironments, that are broad in scope but have at least some direct
                                   or indirect influence on the financial planning process. The external environment includes
                                   economic, legal, social, technological, political, and taxation factors. For the financial plan-
                                   ner, the purpose of studying and monitoring the external environment is to scan for oppor-
                                   tunities and threats that may relate to particular clients and their particular financial goals.
                                   The financial planner may forecast external trends (or use experts to forecast trends) to help
                                   achieve client goals and avoid external risks.
                              2. What are some examples of how each external environmental factor might affect
                                 clients from different economic levels?
             Client’s
          Economic Level                                              External Environmental Forces
                   Economic                   Legal              Social            Political           Taxation          Technological
               G                   A
High-income •    ross domestic  •    ntitrust            S
                                                      •    tatus              •    olitics
                                                                                 P                    I
                                                                                                   •   ncome and           I
                                                                                                                        •   nvestments
clients        product                                   symbols                                      transfer taxes
                                   F
                                •    orm of business                             I
                                                                              •   deology/                                 I
                                                                                                                        •   nternet
               I
            •   nterest rates      organization          L
                                                      •    ife                   stability            P
                                                                                                   •    roperty taxes
                                                         expectancy
Middle-           I
               •   nflation           •    orm of business  •    ustoms/
                                         F                     C              •    oreign trade 
                                                                                 F                 •    roperty taxes
                                                                                                      P                    I
                                                                                                                        •   nvestments
income                                   organization          beliefs           policy
                  I
               •   nterest rates                                                                      I
                                                                                                   •   ncome taxes         J
                                                                                                                        •    obs
clients
                                         E
                                      •    mployer/            L
                                                            •    ife 
                                                                                                      P
                                                                                                   •    ayroll taxes       E
                                                                                                                        •    lectronic tax 
                                         employee              expectancy
                                                                                                                           filing
                                         relationships
                                                                                                                           I
                                                                                                                        •   nternet
                                         C
                                      •    onsumer 
                                         protection
                                         C
                                      •    OBRA
                                         S
                                      •    ocial Security
Low-income        U                W
               •    nemployment •    orkers’                •    ocial 
                                                               S                 G
                                                                              •    overnment          S
                                                                                                   •    ales taxes         E
                                                                                                                        •    lectronic tax 
clients                            compensation                institutions      protectionism                             filing
                  I
               •   nflation                                                                           P
                                                                                                   •    ayroll taxes
                                   C
                                •    onsumer                   L
                                                            •    ife                                                       I
                                                                                                                        •   nternet
                                   protection                  expectancy
                                         C
                                      •    OBRA                C
                                                            •    ustoms/
                                                               beliefs
                                         S
                                      •    ocial Security

                              3. Why is external environmental analysis so important?
                                   External environmental analysis is important for a variety of reasons.
                                   ■■ External trends and particular events play a significant role in effecting change in the
                                      world and in the behavior of individuals.
                                   ■■ Changes in external forces affect beliefs, economics, unemployment, inflation, and a soci-
                                      ety’s well-being.
                                   ■■ The external environment shapes the way people live, work, spend, save, and think.
38   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                         4. How is the external environment analyzed?
                              External environmental analysis is the process of identifying and monitoring the environ-
                              ment in which a client exists and the opportunities and threats that are present. In perform-
                              ing the external environmental analysis, the financial planner must determine the relevance
                              of one or more external environmental factors for a particular client. The relevance of such
                              factors may be dependent on the client’s age, goals, net worth, or income. The regular obser-
                              vation and monitoring of the external environment by the financial planner is essential to
                              providing high-quality financial planning services. Financial planners may study the external
                              environment formally or informally. Formal study usually includes university-level courses in
                              economics, taxation, political science, sociology, and the legal environment. The external
                              environment may be studied informally by using a variety of sources, such as general eco-
                              nomic and business periodicals, books, academic and professional journals, newspapers, and
                              government statistical studies, and by obtaining environmental briefings from various infor-
                              mation providers. Financial planners also take continuing professional education courses to
                              stay abreast of the ever-changing external environment.
                         5. Why is the economic environment so important to financial planning?
                              Of all the external environments, the economic environment has the most direct influence
                              on personal financial planning. The economic environment includes many factors, such
                              as gross domestic product, inflation rates, interest rates, trade payments, consumer income/
                              debt/spending, unemployment, population age, and the index of leading economic indica-
                              tors. Many of these factors, namely interest rates, inflation, unemployment, and gross domes-
                              tic product, play a key role in real investment returns and, therefore, in the accomplishment
                              of financial goals. Professional financial planners must understand the economic environ-
                              ment to better forecast the economic future. By identifying the opportunities and risks that
                              lie ahead, planners can help clients adapt to that future. The planner needs an understand-
                              ing of the current economy’s general condition, the current interest rate environment, the
                              current rate of inflation, and recent changes in monetary and fiscal policy. It is essential for
                              a planner to have the ability to anticipate each element’s behavior and its potential effect
                              on a client’s financial plan.
                         6. What is price elasticity?
                              Price elasticity is the quantity demanded of a good in response to changes in that good’s
                              price. The percentage change in quantity demanded divided by the percentage change in
                              price is a relative measure of price elasticity (PE). Goods differ in their elasticity. A good
                              is elastic when its quantity demanded responds greatly to price changes (PE > 1). Luxuries
                              such as movie tickets and liquor could be considered elastic because they are, generally,
                              highly price sensitive. A good is inelastic when the quantity demanded responds little to
                              price changes (PE < 1). Milk and electricity, considered necessities by some, will remain in
                              demand no matter what the price.
                         7. What is unit elastic demand?
                              Unit elastic demand is the point at which the percentage change in quantity demanded is
                              exactly equal to the percentage change in price, ignoring the direction of the change
                              (PE = 1). For example, a 1% drop in price causes a 1% increase in the amount sold.
                         8. What is marginal utility?
                              Marginal utility is the additional utility received from the consumption of an additional unit
                              of a good.
                                                    Chapter 2 | External Environmental Analysis    39


 9. What is the law of diminishing marginal utility?
    The law of diminishing marginal utility states that as the rate of consumption increases, the
    marginal utility derived from consuming additional units of a good will decline. For example,
    if Richard’s favorite food is steak, he might eat steak often. However, if Richard ate steak
    for n consecutive days for dinner, the enjoyment, or utility, that he received from the dinner
    would be higher the first day than on the last.
10. How do interest rates, taxes, and inflation affect areas of financial planning?
    The interest rate is the price of money. Decreases in interest rates are often followed by peri-
    ods of economic expansion, whereas increases are generally followed by economic contrac-
    tions. Investment returns and purchasing power are two areas that are affected by the rise
    and fall of interest rates. Taxation, in its myriad forms, leaves the taxpayer with less dispos-
    able income. In that sense, all taxes—income taxes, estate transfer taxes, payroll taxes, prop-
    erty taxes, and sales taxes—have a dampening effect on consumer spending and consump-
    tion. Inflation is another important element affecting the economic environment. Inflation
    is an increase in price level. These are three of the main factors affecting financial planning
    in the external environment that must be recognized by the financial planner.
11. What are the components of the business cycle, and how do they affect the
    economy?
    The business cycle consists of two general phases, expansion and contraction, and two
    points, peak and trough. The expansion phase leads to the peak point. During the expan-
    sion phase, business sales rise, Gross Domestic Product (GDP) grows, and unemployment
    declines. The peak point appears at the end of the expansion phase when most businesses
    are operating at full capacity and GDP is increasing rapidly. The peak is the point at which
    GDP is at its highest and exceeds the long-run average GDP. Usually employment levels
    also peak at this point. The contraction phase leads to the trough point. During the contrac-
    tion phase, business sales fall, GDP growth falls, and unemployment increases. The trough
    point appears at the end of the contraction phase where businesses are generally operating at
    their lowest capacity levels. The trough point is characterized by GDP growth at its lowest.
    Unemployment is rapidly increasing and finally peaks when sales fall rapidly.
12. What is the formula for the rate of inflation?

                                    Price level (year t) − Price level (year t − 1)
     Rate of inflation (year t) =                                                   × 100.
                                               Price level (year t − 1)
13. What are the Consumer Price Index, the Gross Domestic Product deflator, and
    the Producer Price Index?
    All three of these price indexes are measures of inflation. The Consumer Price Index (CPI)
    measures the cost of a market basket of 364 items of consumer goods and services, including
    prices of food, clothing, housing, property taxes, fuels, transportation, medical care, college
    tuition, and other commodities purchased for day-to-day living. The GDP deflator is the
    ratio of nominal GDP to real GDP and gives an overall measure of prices in the economy.
    GDP measures goods and services produced within the country regardless of the citizenship
    of the owners. The Producer Price Index (PPI) is the oldest continuous statistical series pub-
    lished by the Labor Department. It measures the level of prices at the wholesale or producer
    stage. It is based on approximately 3,400 commodity prices, including prices of foods, manu-
    factured products, and mining products.
14. What is monetary policy?
    Monetary policy is the control of the money by the Federal Reserve (Fed), which enables
    the Fed to significantly affect short-term interest rates. The Fed will follow a loose, or easy,
    monetary policy when it wants to increase the money supply and thus expand the level of
40   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                              income and employment. In times of inflation and when it wants to constrict the supply of
                              money, the Fed will follow a tight monetary policy.
                        15. What is fiscal policy?
                              Taxation, expenditures, and debt management of the federal government are called fiscal
                              policy. Economic growth, price stability, and full employment are goals that may be pursued
                              by changes in fiscal policy. Changes in taxation will affect corporate earnings, disposable
                              earnings, and the overall economy. As tax rates increase, corporations’ after-tax income
                              declines, which reduces their ability to pay dividends. This may cause the price of equities to
                              decrease. Tax rate increases also reduce individuals’ disposable income and limit the amount
                              of money entering the economy. The demand for tax-free investments is also influenced by
                              changes in taxation levels. Increases in proportional tax rates increase the attractiveness of
                              tax-free instruments.
                        16. What are the Federal Reserve’s three economic goals?
                              The Federal Reserve uses monetary policy to achieve three different economic goals. The
                              first is to maintain sustainable long-term economic growth. The second is to maintain
                              price levels that are supported by that economic growth. The third is to maintain full
                              employment.
                        17. What is the Index of Leading Economic Indicators?
                              The Index of Leading Economic Indicators is a composite index of 10 variables that histori-
                              cally has tended to turn down before the beginning of a business contraction.
                        18. For what is the Index of Leading Economic Indicators used?
                              Monitoring the Index of Leading Economic Indicators (the Index) is useful in forecasting
                              the economy. When the Index declines for three months in a row, it signals a slowdown in
                              economic growth.
                        19. How good is the Index of Leading Economic Indicators as a predictor?
                              The Index has had a reasonable track record in predicting recessions and has accurately pre-
                              dicted every recession since 1950. It has also predicted five recessions that did not happen.
                        20. What are five of the components of the Index of Leading Economic Indicators?
                              Components constituting the Index of Leading Economic Indicators:
                              1.   Length of average workweek in hours, manufacturing
                              2.   Initial weekly claims for unemployment
                              3.   New orders placed with manufacturers for consumer goods
                              4.   Percentage of companies receiving slower deliveries from supplier
                              5.   Contracts and orders for new plant and equipment
                              6.   Permits for new housing starts
                              7.   Internet rate spread, 10-year Treasury bond less federal funds rate
                              8.   S&P 500 Index
                              9.   Money supply (M2)
                            10.    Index of consumer expectations
                        21. What is negligence?
                              Negligence is defined as the failure to act in a way that a reasonably prudent person would
                              have acted under the circumstances—in short, negligence is imprudent behavior. Elements
                                                    Chapter 2 | External Environmental Analysis     41


    of unintentional torts (negligence) include duty, breach of duty, causation, and actual loss.
    Did the person exercise the proper degree of care to carry out his duty, and if not, was that
    the cause of the actual loss suffered by the other party? If so, the actor may be liable for
    negligence.
22. What are considered nondischargable debts in Chapter 7 bankruptcy?
    Once Chapter 7 bankruptcy is completed, most debts are discharged completely and the
    debtor is no longer responsible for their repayment; however, there are certain nondischarge-
    able debts. These nondischargeable debts include back taxes (going back three years); debts
    based on fraud, embezzlement, misappropriation, or defalcation against the debtor acting
    in a fiduciary capacity; alimony; child support; intentional tort claims; property or money
    obtained by the debtor under fraudulent or false pretenses; student loans (unless paying the
    loan will impose an undue hardship on the debtor or the debtor’s dependents); unscheduled
    claims (those not listed while filing for bankruptcy); claims from prior bankruptcy action
    in which the debtor was denied a discharge; consumer debts of more than $500 for luxury
    goods or services owed a single creditor within 40 days of relief; cash advances aggregating
    more than $1,000 as extensions of open-end consumer credit obtained by the debtor within
    20 days of the order relief; and judgments or consent decrees awarded against the debtor for
    liability incurred as a result of the debtor’s operation of a motor vehicle while intoxicated.
23. List some examples of federal consumer protection laws.
     Law                                  Purpose
     Fair Packaging and Labeling Act      To prohibit deceptive labeling and require disclosure
     Equal Credit Opportunity Act         To prohibit discrimination in granting credit 
     Fair Credit Reporting Act            To regulate the consumer credit reporting industry
     Fair Credit Billing Act              To regulate consumer credit billing practices 
     Truth-in-Lending Act                 To require disclosure of terms
     Magnuson-Moss Warranty Act           To regulate consumer product warranty
     Fair Debt Collection Act             To prevent abusive or deceptive debt collection practices
     Federal Bankruptcy Laws              To adjust consumer debt and allow for a fresh start
     Consumer Protection at State Level   To protect against unfair business practices
     Antitrust Legislation                To prevent monopolistic price practices
     Federal Trade Commission Act         To prohibit unfair and deceptive acts of commerce


24. What are some examples of federal programs that offer protection for workers on
    the job site?
    The Occupational Safety and Health Act (OSHA) ensures safe and healthy working condi-
    tions for employees. Workers’ Compensation Acts are enacted both at the federal and state
    level and impose a form of strict liability on employers for accidental injuries occurring in
    the workplace. Unemployment compensation is a federal and state financial security pro-
    gram that provides for temporary payments to workers who, through no fault of their own,
    become unemployed. Social Security is a federal financial security program that provides
    some replacement income lost as a result of retirement, disability, or survivorship. The
    Employee Retirement Income Security Act (ERISA) was passed to protect the financial
    security of employees by protecting employee rights in qualified retirement plans. The
    Consolidated Omnibus Budget Reconciliation Act of 1986 (COBRA) requires that employ-
    ees and certain dependents of employees be allowed to continue their group health insur-
    ance coverage following a qualifying loss of coverage.
42   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                        25. Identify two federal securities acts that protect investors.
                              The Securities Acts of 1933 and 1934 were passed to protect investors and to regulate those
                              providing investment services. The Securities Act of 1933 is primarily concerned with new
                              issues of securities or issues in the primary market. It requires that all relevant information
                              on new issues be fully disclosed, that new securities be registered with the SEC, and that
                              audited financial statements be filed with the registration statements, and forbids fraud
                              and deception. Although the Securities Act of 1933 was limited to new issues, the 1934
                              Securities Act extended the regulation to securities sold in the secondary markets.
                        26. How do the external environmental factors—social, technological, political, and
                            taxation—affect a client’s financial plan?
                              Financial planners must accurately assess the social environment and forecast the threats
                              and opportunities that change will bring. Perhaps the most rapidly changing environment
                              is that of technology. Success will come from keeping a constant vigil on the characteristics
                              that make up the technological environment. The political environment is especially impor-
                              tant to risk analysis in investments. This analysis becomes more important as we move to a
                              global economy and try to diversify investment portfolios with worldwide investments. If a
                              professional financial planner is to assist clients in minimizing their legal taxes, thus giving
                              them more disposable income for consumption, savings, and investments, the planner must
                              have a basic education in taxation and must find ways to remain current in the field.
                                                           Chapter 2 | External Environmental Analysis     43




EXERCISES AND SOLUTIONS
        1. Define the laws of supply and demand.
           The law of demand states that as the price of a product decreases, the demand for the prod-
           uct increases and vice versa. The law of supply states that there is a positive relationship
           between the price of a product and the amount producers are willing to produce (i.e., the
           higher the price, the more producers will produce; the lower the price, the less producers
           will produce).
        2. What does it mean if the demand for a product is inelastic?
           An increase in the price would not lead to a large change in demand.
        3. What action might the Federal Reserve take if it wanted to lower interest rates?
           The Fed could lower the discount rate, reduce the reserve requirement, or purchase govern-
           ment securities on the open market.
        4. What is the price adjustment process in a competitive market, and how does it
           shift?
           The price adjustment process is the process of balancing supply and demand, and it moves to
           equilibrium where supply equals demand.
        5. What happens in the marketplace when the supply curve decreases, or shifts to
           the left?
           Some firms leave the industry. Less is produced at all price levels until equilibrium is once
           again achieved.
        6. Describe what has occurred when the price of a particular product decreases and
           consumers buy more of that product.
           An increase in the quantity demanded has taken place, or a movement along the demand
           curve.
        7. Consumer demand for sugar at $.80 per pound results in 1,000 pounds sold.
           A drop in sugar price to $.50 per pound results in 1,250 pounds sold. Is the
           demand for sugar inelastic, elastic, or unit elastic? (Ignore negative sign for PE
           calculation.)
           The demand is inelastic.

           % change in quantity demanded (1, 250 − 1, 000) ÷ 1, 000 25.0%
                                                        0
                                        =                          =       = 0.667
                 % change in price             (50 − 80) ÷ 80        37.5%

        8. If a substitute good is readily available for a product, is the product demand
           likely to be elastic or inelastic?
           Elastic. If there is a substitute good, the demand for the original product will be elastic.
        9. Give an example illustrating the law of downward-sloping demand.
           Consumers demanding more at lower prices is an example of downward-sloping demand. For
           example, gasoline consumption is greater at lower prices.
44   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                        10. An increase in the price of product A causes a decrease in the demand for
                            product B. What is the relationship between the two products?
                              If an increase in the price of good A causes a decrease in the demand for product B, the
                              goods are complements.
                        11. Describe reasons for a change in consumer demand.
                              ■■ Changes in consumer tastes and income, advertising, news reports, trends, and seasons
                                   can all affect consumer tastes. As income rises, consumers tend to buy more; if income
                                   declines, consumers buy less.
                              ■■ Prices of related products—sometimes substitutes can be used in place of products.

                        12. Which of the following might cause an increase in supply?
                              ■■ A decrease in productivity

                              ■■ Fewer sellers in the marketplace

                              ■■ More efficient technology

                              ■■ A decrease in government subsidies

                              A key element that affects supply is the cost of production. Technology that is more effi-
                              cient will decrease the cost of production, thus increasing supply. A decrease in productiv-
                              ity and fewer sellers will decrease supply. Decreasing government subsidies will also reduce
                              production.
                        13. Identify several determinants of demand elasticity.
                              Elasticity of demand is an indicator of responsiveness of quantity demanded to changes in
                              price in the market. The following may affect the demand for a product and are determi-
                              nants of demand elasticity:
                              1.    Whether the purchase of the product can be delayed
                              2.    Whether there are adequate substitutes for the product
                              3.    Whether the purchase of the product requires a large portion of income
                              4.    Whether the product has utility
                        14. If the quantity supplied does not change significantly with a change in price, is
                            the type of supply elastic or inelastic?
                              Supply is inelastic. Elasticity of supply indicates the amount of quantity supplied in response
                              to a given change in price. If the amount supplied is fixed or does not change significantly,
                              the supply is inelastic.
                        15. Define inflation.
                              Inflation is defined as an increase in the general level of prices.
                        16. How would someone living on a fixed income be affected by inflation?
                              Inflation means generally rising prices for goods and services. Someone on a fixed income in
                              a time of rising prices will be forced to purchase less and, therefore, have declining purchas-
                              ing power. Although his nominal income would remain constant, his real income would be
                              decreasing. Note that Social Security is inflation adjusted but many pension plans are not.
                        17. When the economy is slowing and unemployment is increasing, what phase of
                            the business cycle are we in?
                              A slowing economy and increasing unemployment characterize the contraction phase of the
                              business cycle.
                                                  Chapter 2 | External Environmental Analysis    45


18. Which of the following economic activities represent examples of monetary
    policy?
    ■■ The federal funds rate is increased.

    ■■ The Federal Reserve lowers bank reserve requirements.

    ■■ The Federal Open Market Committee sells securities.

    All are examples of monetary policy.
19. What action taken by the Fed will lead to increased money supply?
    Lowering the discount rate, decreasing required bank reserves, or buying securities on the
    open market.
20. Identify the phases and points of a typical business cycle.
    Trough, expansion, peak, contraction. A typical business cycle can be measured from trough
    to trough or from peak to peak with expansion and contraction in between. Contraction fol-
    lows a peak and expansion follows a trough.
21. In a typical business cycle, which phases exhibit periods of increasing employ-
    ment and increasing output?
    Expansion. An expansion is where employment and output are rising. When employment
    and output are no longer rising, the phase is at its peak. If employment and output begin to
    decrease, this indicates a contraction phase. Finally, when employment and output are no
    longer decreasing, the cycle has reached a trough. The intensity indicates the highest and
    lowest points of the peak or the trough.
46    Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition




     PROBLEMS AND SOLUTIONS

                          1. Identify whether each of the following involves a shift in the demand curve or a
                             change in the quantity demanded.
                               A. Fish prices fall after the Pope allows Catholics to eat meat on Friday.
                               B. Auto sales decrease as a result of increased unemployment.
                               C. Gasoline consumption increases as some of the taxes on gasoline are lowered.
                               D. After a drought hits Louisiana, crawfish sales decrease.
                                     A. Shift in the demand curve
                                     B. Shift in the demand curve
                                     C. Change in quantity demanded
                                     D. Change in quantity demanded (The supply curve shifts left, causing the equilibrium
                                        point to move and price to increase.)
                          2. If the cost of one year of college education on January 1 of 2007, 2008, and
                             2009 is $25,000, $26,000, and $27,500 respectively, what was the rate of edu-
                             cation inflation for 2007 and 2008? What was the annualized education inflation
                             rate from 2007 to 2009?

                                                              26,000 − 25,000
                               2007 education inflation:                      = 4%
                                                                  25,000

                                                              27,500 − 26,000
                               2008 education inflation:                      = 5.77%
                                                                  26,000

                               2006–2008 annualized education inflation rate:

                                PV       =    $25,000
                                FV       = ($27,500)
                                n        = 2
                                i        = 4.88%
                          3. Homer, age 38, is married with three children. He has the following liquid assets
                             on deposits with his bank, which is an FDIC-insured institution.

                                                        Account                 Ownership         Balance
                                                        CD                      Homer             $200,000
                                                        Savings                 Homer with wife     $50,000
                                                        IRA                     Homer               $75,000
                                                        Checking account        Homer               $90,000

                               What is the total amount currently insured by the FDIC?
                               The FDIC insures separate legal categories of accounts of a legal institution. As a result, the
                               IRA will be insured up to $75,000 ($250,000 limit). The individual accounts owned by John
                               are aggregated and are insured up to $250,000 in total. The joint account will be insured for
                               $50,000. Therefore, the current total amount insured by the FDIC is $375,000.
58    Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition




     DISCUSSION QUESTIONS AND SOLUTIONS

                          1. How does a financial planner successfully communicate respect, trust, and empa-
                             thy to a client?
                               Respect can be portrayed in several ways. One obvious way is the manner in which the cli-
                               ent is addressed. On first meeting, the client should be addressed with a courteous title such
                               as Mr., Ms., or Dr. If the client later indicates a preference to be called by a first name or
                               some other nickname, that desire should be met. Listening to the client and showing value
                               for his time also portray respect.
                               Trust needs to be earned, but the process can be expedited by showing evidence that others
                               deem you trustworthy. Provide letters of reference from previous clients and specific exam-
                               ples of how other clients have benefited from your skills. However, in doing this, care must
                               be taken to maintain the duty of confidentiality.
                               Having regard for the clients’ views and values shows empathy. Therefore, the financial
                               planner needs to identify with and understand the clients’ situations, feelings, and motives.
                               The financial planner must understand the client’s perspective and show respect for that
                               perspective.
                          2. Which techniques can be used to reduce the risk of misinterpretation and misun-
                             derstanding when communicating with a client?
                               Remove ambiguity—Tell the client what will happen, what is happening as it happens, and
                               what has happened when it is completed.
                               Clarify statements—Avoid general statements by using clarification techniques such as
                               restating, paraphrasing, and summarizing. Apply the ideas of “is” and “is not.”
                               Seek information—Use open-ended questions to draw out relevant information. Do not
                               make assumptions. Question everything. Question the answers to the questions.
                               Be specific—When communicating with the client, identify the what, where, when,
                               responsible party, and extent to describe a task or a result. Avoid slang and colloquialisms.
                               Articulate goals in terms of time, place, and form.
                          3. What is the purpose of an engagement letter?
                               An engagement letter ensures understanding between the client and the planner. The letter
                               should memorialize previous conversations with the client. The letter should also contain
                               information about any agreements or understandings that were obtained during previous
                               meetings, including the plan of action for developing a financial plan, the expected outcome
                               of the engagement, and the method and amounts of compensation.
                          4. To what common law liabilities is the financial planner exposed?
                               Financial planners are exposed to liabilities due to breach of contract, negligence, and fraud.
                          5. How do the Securities Act of 1933 and the Securities Exchange Act of 1934
                             affect financial planners?
                               The Securities Act of 1933 regulates new issues of investment securities and requires public
                               offerings to be registered with the Securities and Exchange Commission (SEC). Financial
                               planners are prohibited from making untrue or misleading statements in documents they
                               prepare for registration with the SEC. The Securities Exchange Act of 1934 regulates the
                               purchase and sale of investment securities in the market. Financial planners must not make
                               false or misleading statements in documents filed with the SEC, trade on nonpublic material
                               information without disclosure, or use manipulative or deceptive devices in connection with
                               the sale or purchase of securities.
                                             Chapter 3 | Communication and Internal Analysis   59


6. What four thinking phases does a client progress through during the financial
   planning process? What can the financial planner do to help the client progress
   through the common thinking phases? In which phase is it most common for a
   client to seek the assistance of a financial planner? In which phase is the finan-
   cial mission most likely to be achieved?
   Linear thinking—Generally, individuals are focused on accomplishing a particular goal or
   objective.
   Paradoxical thinking—During this phase, the client begins to focus on several simultaneous
   objectives. As a result, it is common for individuals to become frustrated during this phase.
   They may become overwhelmed with the amount of financial planning required and dis-
   cover that many of their objectives conflict with each other. The client is most likely to seek
   the assistance of a financial planner in this phase.
   Abstract thinking—During the abstract thinking phase, clients begin to integrate the finan-
   cial plan into their daily lives. They become aware of the consequences of their financial
   actions and can conceptually understand how savings and consumption decisions impact
   their financial plan.
   High cognitive thinking—This is the ultimate phase of thinking; the client becomes
   enlightened and is likely to achieve his mission.
   The financial planner can assist the client in progressing through the common thinking
   phases by assuring him that the emotions, confusion, and conflict he is experiencing are
   common and can be overcome through education and good planning.
7. Define the auditory learning style, the visual learning style, and the kinetic, or
   tactile, learning style, and explain how a client with each style prefers to learn.
   Clients with an auditory learning style generally talk about situations, express emotions ver-
   bally, enjoy listening but are impatient to talk, and tend to move lips or subvocalize when
   reading. They prefer to learn by verbal instruction.
   Clients with a visual learning style seem to enjoy watching demonstrations, have intense
   concentration and an ability to visually imagine information, write things down and take
   detailed notes, doodle, and look around studying the environment. They prefer to learn by
   written information, especially with charts, graphs, and pictures.
   Clients with a kinetic learning style generally fidget when reading; are easily distracted when
   not able to move; express emotions physically by jumping and gesturing; do not listen well
   and try things out by touching, feeling, and manipulating; and need frequent breaks during
   meetings. They prefer to learn by manipulating and testing information.
8. What five categories make up a client’s internal environment?
   The five general categories that make up a client’s internal environment include the client’s:
   ■ life cycle position;
   ■ attitudes and beliefs;
   ■ special needs;
   ■ financial position; and
   ■ perception of their financial situation.
60   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                         9. Which factors make up a client's life cycle positioning?
                              The factors which make up the client’s life cycle positioning include:
                              ■ age;
                              ■ marital status;
                              ■ dependents;
                              ■ income level; and
                              ■ net worth.
                        10. What are the life cycle phases through which financial planning clients usually
                            pass?
                              Asset accumulation phase—Begins somewhere between the ages of 20 and 25 and lasts
                              until around age 50. The beginning of the phase is characterized by limited excess funds for
                              investing, high degree of debt, and low net worth.
                              Conservation/protection phase—Begins when one has acquired some assets, usually in late
                              30s or 40s, and may last throughout the work life expectancy. Making payments for chil-
                              dren’s education and saving for retirement frequently characterize this phase.
                              Distribution/gifting phase—May begin as early as the late 40s and continue until death.
                              Generally, this phase begins subtly when the person realizes he can afford to spend on things
                              he never believed possible.
                        11. Explain how the following affects the setting of financial goals by the client:
                              ■ Tolerance for risk
                              ■ Savings and consumption habits
                              ■ Views about employment, retirement, and leisure time
                              ■ Attitudes on government (especially taxation)
                              The type of investments and the style of risk management that are best for the client are
                              determined by knowing the client’s tolerance for risk. A client’s savings and consumption
                              habits also affect the client’s goals. For example, if the client does not have a history of sav-
                              ing money consistently, it would be wise to develop a strategy in which money is directed
                              into savings before the client receives a paycheck. Similarly, if the client has a history of
                              making large dollar purchases impulsively, it would be wise to encourage investments in
                              assets with early withdrawal penalties or those where withdrawal is difficult.
                              A client’s view on employment, retirement, and leisure time is also useful to a financial
                              planner because it provides information about likely behavior. If a person is discontent
                              with his job or places a high value on leisure time, he may be more likely to take spontane-
                              ous vacations. Therefore, the financial planner may want to incorporate these likely but
                              unplanned expenditures into the financial strategy.
                              A client’s attitude toward government may also affect financial goals. If a client believes that
                              government expenditures are wise and useful to the public, that client will probably be less
                              resistant to taxation than a client who believes that government essentially wastes whatever
                              money it receives. These attitudes toward tax and government translate into financial plan-
                              ning issues in numerous ways. Some clients ignore taxes and their role in financial planning.
                              Other clients are tax conscious and simply view the tax environment as one in which they
                              live and must take into consideration. Still, other clients are so excessively focused on tax
                              minimization that they spend extraordinary time and resources on the tax minimization
                              objective, sometimes to the detriment of other goals.
                                             Chapter 3 | Communication and Internal Analysis   61


12. What are the special needs that may influence the successful development of a
    client’s financial plan?
    Special needs that may influence the successful development of a client’s financial plan
    include needs of dependent persons, divorce, remarriage, nontraditional family consider-
    ations, terminal illness, and career change.
13. Which financial statements are needed to develop an accurate assessment of a
    client’s financial position? What other information is important?
    Financial statements that are needed to develop an accurate assessment of a client’s financial
    position include the balance sheet (for businesses), the income statement (for businesses),
    statement of financial position, the statement of cash flows, and the statement of change in
    net worth. In addition to financial statements, the financial planner must collect informa-
    tion about the client’s insurance policies and coverage, investments, retirement, and other
    employee benefits. The client’s historical tax returns are useful, as is information about any
    wills, trusts, or other estate planning documents. The planner should be aware of any powers
    of attorney the client may have or may have given.
14. How does a client’s subjective perception of his financial position affect the
    objective reality of the financial position provided by a financial planner?
    The gap between perception and reality directly influences the amount of client education
    required. The greater the gap, the greater the amount of education needed.
62    Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition




     EXERCISES AND SOLUTIONS

                          1. Upon first meeting, how should you address your client?
                               The financial planner should address clients using an appropriate courteous title, such as
                               Ms., Mr., or Dr. Using formal titles until your client requests otherwise shows respect for
                               your client.
                          2. What are some techniques that can be used to clarify statements when speaking
                             with a client?
                               Restating a statement, paraphrasing, and summarizing are all techniques that should be used
                               to assist in clarifying statements.
                               Asking “is” and “is not” questions about whatever the client is trying to describe.
                               Using “is” and “is not” statements about whatever you are trying to describe.
                          3. Nancy is a financial planner. Her client, Mr. Martin, is 62 years old and retired.
                             His Social Security and pension plan benefits barely cover his living expenses.
                             His two assets are his personal residence and a brokerage account of $600,000
                             invested in conservative mutual funds. Nancy advises Mr. Martin to sell all of
                             his mutual fund shares and invest the proceeds in commercial real estate. If Mr.
                             Martin follows Nancy’s advice and subsequently loses $300,000, will Nancy be
                             liable for fraud?
                               Nancy will likely be liable for negligence but not for fraud because she has not made a false
                               statement.
                          4. If you noticed that your client was taking notes and occasionally doodling while
                             you spoke with him, what would you assume his learning style to be, and how
                             would you educate him regarding financial planning information?
                               His learning style is probably visual. Therefore, you should provide him with written infor-
                               mation, especially with charts, graphs, and pictures.
                          5. If your client is 30 years old, has no children, and has a moderate income and
                             net worth, what are the risks he is most likely seeking to avoid?
                               Most clients in this life cycle position are seeking to avoid risks associated with health prob-
                               lems, disability, loss of personal property, and liability. Clients with this profile are probably
                               not very concerned with obtaining life insurance or long-term care insurance.
                          6. If your clients are 73 years old, retired, have adult children and grandchildren,
                             and a high net worth, which life cycle phase are they most likely in?
                               Clients with this profile are most likely in the distributing/gifting phase. Because your clients
                               have a high net worth and are 73 years old, they are probably beyond the conservation/pro-
                               tection phase.
                          7. What might be the common goals of a client who is 24 years old and single with
                             a modest income?
                               The common goals for a client with this profile would be to increase or establish savings,
                               establish investments, accumulate wealth while managing debt, and possibly acquire a per-
                               sonal residence.
                                             Chapter 3 | Communication and Internal Analysis   63


8. If your client is interested in saving for retirement but has a history of using
   savings planned for the long term on current purchases such as vacations and
   vehicles, what type of savings plan would you recommend?
   The best type of savings plan for a client with a history of using savings meant for the long
   term is one that prohibits withdrawal or that has a high penalty for early withdrawal.
64    Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition




     PROBLEMS AND SOLUTIONS

                          1. Write an engagement letter to conduct comprehensive personal financial planning
                             for the Nelsons.
                               The student should prepare an engagement letter similar to the one on page 49 of the text-
                               book. The student’s engagement letter should include the Nelsons’ names, the student’s
                               name as the planner, and a description of possible objectives and goals.
                          2. Identify the life cycle position and related risks most likely to affect the achieve-
                             ment of the Nelsons’ general goals.
                                     NelsoN Family Case sCeNario


                                        The Nelsons recently visited you, their financial planner. After initial discussions and
                                        completion of a client data questionnaire similar to the one presented in Appendix
                                        3-A, you have gathered the following information. (The Nelson family will be used
                                        throughout the text for various examples and explanations.)


                                                                        DAVID AND DANA NELSON
                                                                               As of 1/1/2010


                                        PERSONAL BACKGROUND AND INFORMATION
                                        David Nelson (age 37) is a bank vice president. He has been employed by the
                                        bank for 12 years and has an annual salary of $70, 000. Dana Nelson (age 37) is a
                                        full-time homemaker. David and Dana have been married for eight years. They have
                                        two children, John (age 6) and Gabrielle (age 3), and are expecting their third child
                                        in two weeks. They have always lived in this community and expect to remain in
                                        their current residence indefinitely.

                                        GENERAL GOALS (not prioritized)
                                        Save for college education
                                        Reduce debt
                                        Save for retirement
                                        Estate planning
                                        Invest wisely

                               David and Dana are both 37 years old. They are married with two dependent children and
                               one on the way. David’s annual salary is $70,000, and Dana does not earn a salary. The
                               Nelsons are most likely in the asset accumulation phase and are subject to life, health, dis-
                               ability, property, and liability risks.
                                      Chapter 4 | Personal Financial Statements (Preparation and Analysis)   89




DISCUSSION QUESTIONS AND SOLUTIONS
        1. What is the relationship between GAAP/FASB and personal financial
           statements?
           The Financial Accounting Standards Board (FASB) is a nongovernmental board that
           sets the standards for financial statements and generally accepted accounting principles
           (GAAP). While these GAAP generally apply to companies, they are also useful in the
           development of personal financial statements. The objectives in following such accounting
           conventions include consistency and comparability in the preparation and presentation of
           financial statements.
        2. Describe some of the uses of personal financial statements.
           Preparing personal budgets, evaluating spending patterns, determining the financial solvency
           of the client, determining whether financial goals are being achieved, determining whether
           the client is making adequate progress towards retirement, evaluating the relative risk and
           performance of the investment portfolio, evaluating the client’s use and cost of debt, deter-
           mining the adequacy of income replacement insurance, determining the adequacy of liquid-
           ity for estate planning, evaluating net worth, and determining the adequacy for loans.
        3. What is the purpose of the statement of financial position?
           The statement is a financial snapshot of the client at a moment in time (the date of the
           statement). Historically, the statement of financial position was the primary financial state-
           ment given to and relied upon by third parties. It was originally designed to meet the needs
           of creditors who wanted information about assets, collateral, and a person’s ability to repay
           debts (net worth).
        4. What items are included on the statement of financial position?
           Assets, liabilities, and net worth.
        5. Discuss the presentation of the statement of financial position (i.e., how items are
           listed and why).
           The statement of financial position lists assets on the left in order of liquidity, with the most
           liquid on the top. The liabilities are listed in the same manner in the right column. The net
           worth of the client is listed below the liabilities. Regardless of the categorization of assets
           and liabilities, the statement must always balance.
        6. What is the purpose of the personal statement of cash flows?
           The personal statement of cash flows presents a summary of the client’s income and
           expenses during an interval of time, usually one year. This statement may focus on realized
           transactions and, if so, is helpful when comparing to budgeted financial goals. The personal
           statement of cash flows may also be prepared pro forma (in advance) and, therefore, used for
           budgeting or for projections.
        7. What items are included on the personal statement of cash flows?
           The personal statement of cash flows contains income, savings, and expenses.
        8. Discuss the presentation of the personal statement of cash flows (i.e., how items
           are listed and why).
           The personal statement of cash flows lists the income first so that the total amount available
           for expenses can be seen. From this we deduct savings in which the client participated. Then
           the expenses, including ordinary living expenses, debt payments, insurance premiums, tuition/
           education expenses, and taxes are deducted. The remaining amount will be the discretionary
           cash flow.
90   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                         9. What is the purpose of the statement of changes in net worth?
                              The statement of changes in net worth summarizes non-cash flow changes in net worth
                              occurring between one statement of financial position and the next.
                        10. What items are included on the statement of net worth?
                              Items on the statement of net worth include changes in value for assets due to either appre-
                              ciation or depreciation, whether an asset other than cash is exchanged for some other assets
                              (real estate for real estate), whether assets other than cash are received by gift or inheri-
                              tance (property), and whether assets other than cash are given to charities or noncharitable
                              donees (automobiles, buildings, or investments).
                        11. Discuss the presentation of the statement of net worth (i.e., how items are listed
                            and why).
                              First, the positive non-cash flow adjustments to net worth are made (additions to net
                              worth). Then the negative non-cash flow adjustments to net worth are made (reductions in
                              net worth). Then, the ending net worth can be computed.
                        12. What are the differences between long-term and current assets/liabilities?
                              Long-term assets are assets owned completely or partially by the client that will not be con-
                              verted to cash within one year. Current assets are assets expected to be converted to cash
                              within one year. Long-term liabilities are those debts that will not be paid off within one
                              year, usually debts of larger assets. Current liabilities include any short-term credit card debt
                              and unpaid bills.
                        13. Why are financial ratios important to financial planning?
                              The ratios are used to clarify and improve understanding of the numbers and are used in
                              comparison to established benchmarks to make judgments as to their appropriateness for a
                              certain client.
                        14. What is the importance of keeping accurate and up-to-date financial statements?
                              Financial statements represent the scoring mechanism for recording and evaluating an
                              individual’s financial performance. This would not be possible if financial statements were
                              not accurate or up-to-date. Financial statements are also used by clients to benchmark
                              goal achievement, by planners to help clients decide financial direction, and by credi-
                              tors and lenders who are making an evaluation as to whether to extend, continue, or call
                              indebtedness.
                        15. What is fair market value?
                              Fair market value is defined as the price at which an exchange will take place between a
                              willing buyer and a willing seller, both reasonably informed and neither under duress to
                              exchange.
                        16. What is liquidity?
                              Liquidity is the length of time expected for the asset to be converted back to cash.
                        17. Why do we prepare three financial statements?
                              The three financial statements by themselves (the statement of financial position, the per-
                              sonal statement of cash flows, and the statement of changes in net worth) do not present the
                              entire financial picture of the individual. All the statements must be analyzed together to
                              clarify the financial picture of the client.
                              Chapter 4 | Personal Financial Statements (Preparation and Analysis)   91


18. Discuss the importance of vertical analysis.
    Vertical analysis of financial statements presents each statement in percentage terms.
    Usually, the statement of financial position is presented with each item as a percentage of
    total assets, while the personal statement of cash flows is prepared with each item as a per-
    centage of total income. Percentage items allow us to compare items over time where we
    have multiple-year financial statements for the same client. The comparison of one state-
    ment on a percentage basis is called common size analysis because the percentages calculated
    ignore absolute dollar size and provide information regarding stability or instability of each
    account in percentage terms.
19. What are some of the limitations of personal financial statements?
    Inflation, the use of estimates, and benchmarks all are limitations of personal financial
    statements.
20. What is the purpose of budgeting?
    Information about a client’s saving and consumption habits assists the planner in developing a
    successful strategic financial plan for the client. Budgeting is the process of projecting, moni-
    toring, adjusting, and controlling future income and expenditures according to this plan.
21. List the different types of home mortgages and their characteristics.
    Fixed-rate mortgages offer a level interest rate for the term of the loan and a fixed payment
    amortization schedule. The payments are selected such that at the end of the term (30 or
    15 years), the principal is completely repaid.
    With a variable-rate loan, or adjustable-rate mortgage (ARM), the borrower is charged
    interest based on a benchmark such as the 90-day Treasury bill rate. The interest rate will
    change monthly based on changes in the benchmark rate. Many variable-rate mortgages
    limit the amount by which the interest rate can change monthly and yearly. The downside
    risk to an ARM is the prospect of the interest rate increasing periodically causing the pay-
    ment to increase proportionally. An advantage of an ARM is that, due to the low initial
    interest rate, the principal and interest (P&I) payments are low relative to a 30-year fixed-
    rate mortgage.
    Balloon mortgages can have fixed interest rates or adjustable interest rates, but the term will
    be less than the period required to amortize the loan.
92    Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition




     EXERCISES and SolutIonS
                          1. What is the balancing equation for the statement of financial position?
                               Assets = Liabilities + Net worth
                          2. What do current assets and current liabilities have in common?
                               These are items that will be converted to cash (assets) or satisfied (liabilities) within 1 year.
                          3. Your client purchased new living room furniture for $6,500 last month. Which
                             financial statement(s) would this purchase affect and how?
                               This item would be featured on the following statements:
                               ■ Statement of net worth as an increase to assets (table)
                               ■ Ending statement of financial position to show the decrease in cash and the increase in
                                 the furniture/household category
                          4. How would each of the following items affect net worth?
                               A. Repayment of a loan using funds from a savings account
                               B. Purchase of an automobile that is 75% financed with a 25% down payment
                               C. The S&P 500 increases, and the client has an S&P indexed mutual fund
                               D. Interest rates increase, and the client has a substantial bond portfolio
                               Statements A (repayment of a loan using funds from a savings account) and B (purchase of
                               an automobile that is 75% financed with a 25% down payment) do not affect net worth.
                               Statement C (the S&P 500 increases, and the client has an S&P indexed mutual fund)
                               would increase net worth, and Statement D (interest rates increase, and the client has a sub-
                               stantial bond portfolio) would decrease net worth.
                          5. Lauren and Herb have the following assets and liabilities:
                                                             Liquid assets                        $6,750
                                                             Investment assets                  $16,250
                                                             House                             $125,000
                                                             Current liabilities                  $3,100
                                                             Long-term liabilities              $86,000

                                               Calculate the total assets, total liabilities, and net worth.
                                               Assets                                  Liabilities & Net Worth
                                               Liquid assets               $6,750      Current liabilities               $3,100
                                               Investment assets         $16,250       Long-term liabilities            $86,000
                                               House                    $125,000       Total liabilities                $89,100
                                                                                       Net worth                        $58,900
                                               Total assets             $148,000       Total liabilities & net worth   $148,000
                             Chapter 4 | Personal Financial Statements (Preparation and Analysis)   93


6. Calculate the current ratio based on the facts given in the previous question.

                                         $6,750
                                                = 2.1774
                                         $3,100


7. After reviewing Kenny and Jane’s financial statements, the following information
   was determined:
                         Liquid assets                                   $3,976
                         Investment assets                              $10,738
                         Annual nondiscretionary expenses               $13,913
                         Current liabilities                             $ 9,247
   Calculate this couple’s emergency fund ratio. Does it fall within the target goal?

                                          3,976
                                                    = 3.43
                                      (13,913 ÷ 12)


   Yes, it falls within the target goal of 3–6 months.
8. After reviewing Matt and Jennifer’s personal statement of cash flows, the follow-
   ing information was determined:
                         Mortgage principal                               $5,467
                         Mortgage interest                              $21,500
                         Property tax                                     $2,000
                         Homeowners insurance premium                     $1,800
   The couple has a monthly gross income of $9,500. Has this couple taken on debt in
   excess of what is reasonable for their income, according to benchmarks set by mortgage
   lenders?

            [(5,467 + 21,500 + 2,000 + 1,800) ÷ 12]
                                                    = 27%
                             9,500
                                                                                      .
            No, their debt is not excessive because 27% is less than the 28% benchmark.


9. In addition to the information in Exercise 8, Matt and Jennifer had other annual
   debt payments of $11,600. Calculate the monthly housing costs and other debt
   repayments to monthly gross income ratio. Do Matt and Jennifer qualify for a
   mortgage loan?

           [(30,767 ÷ 12) + (11,600 ÷ 12)]
                                           = 37%
                        9,500

           They do not qualify for a mortgage because the ratio is more than the 36%
           benchmark.
94   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                        10. Mariska and Bryant have the following assets and liabilities:
                                                            Checking account               $2,000
                                                            House                       $125,000
                                                            Savings account                $3,000
                                                            CDs                            $5,000
                                                            Automobile                   $13,500
                                                            Stocks                       $10,000
                                                            Utilities                        $500
                                                            Mortgage                     $80,000
                                                            Auto loan                      $5,000
                                                            Credit card bills              $1,500

                              Determine their net worth.

                                           Assets                                     Liabilities and Net Worth
                                           Checking account               $2,000      Utilities                            $500
                                           Savings account                $3,000      Credit card bills                   $1,500
                                           CDs                            $5,000      Auto loan                           $ 5,000
                                           Stocks                        $10,000      Mortgage                          $ 80,000
                                           Automobile                    $13,500      Total liabilities                 $ 87,000
                                           House                        $125,000      Net worth                         $ 71,500
                                           Total assets                 $158,500      Total liabilities & net worth     $158,500

                        11. Use the following items to determine total assets, total liabilities, net worth, total
                            income (cash inflows), and total expense items (cash outflows):
                                           Net monthly salary                                                 $2,280
                                           Rent                                                                 $750
                                           Savings account balance                                            $2,000
                                           Auto loan payment                                                    $416
                                           Money market investments account balance                           $4,800
                                           Clothing expense                                                     $150
                                           Value of home computer                                             $1,200
                                           Groceries expense                                                    $220
                                           Entertainment expense                                                $130
                                           Value of autos                                                   $10,800
                                           Student loan payment                                                 $212
                                           Utilities expense                                                    $510
                                           Laundry expense                                                        $46
                                           Insurance                                                            $368
                                           Balance of student loan                                            $8,625
                                           Note: Income and expense items are monthly.
                             Chapter 4 | Personal Financial Statements (Preparation and Analysis)   95



            Assets                                  Liabilities & Net Worth
            Savings                   $2,000        Student loan                           $8,625
            Money market              $4,800        Total liabilities                      $8,625
            Value of autos          $10,800
            Value of computer         $1,200        Net worth                             $10,175
            Total assets            $18,800         Total liabilities & net worth         $18,800


           Total Cash Inflows                    Total Cash Outflows
           Salary                 $27,360        Rent                               $9,000
                                                 Auto payments                      $4,992
                                                 Clothing expense                   $1,800
                                                 Groceries                          $2,640
                                                 Entertainment expense              $1,560
                                                 Student loan payment               $2,544
                                                 Utilities                          $6,120
                                                 Laundry expense                      $552
                                                 Insurance                          $4,416
           Total Cash Inflows     $27,360        Total Cash Outflows              $33,624
           (income)                              (expenses)


12. The Coopers have a net worth of $250,000 before any of the following
    transactions:
    ■■   Paid off credit cards of $9,000 using a savings account
    ■■   Transferred $5,000 from checking to their IRAs
    ■■   Purchased $2,500 of furniture with credit

    What is the Coopers’ net worth after these transactions?
    The net worth does not change with any of these transactions; it is still $250,000.
13. What are the advantages of performing vertical analysis on financial statements?
    Vertical analysis of financial statements presents each statement in percentage terms.
    Usually, the statement of financial position is presented with each item as a percentage of
    total assets, while the personal statement of cash flows is prepared with each item as a per-
    centage of total income. Percentage items allow us to compare items over time where we
    have multiple-year financial statements for the same client. The comparison of one state-
    ment on a percentage basis is called common size analysis because the percentages calculated
    ignore absolute dollar size and provide information regarding the stability or instability of
    each account in percentage terms.
14. Explain how inflation limits financial statement analysis.
    Because inflation exists, if we are to compare multiple reporting periods, we must adjust cer-
    tain numbers either to current dollars (inflated dollars) or to some base percentage or index.
    Inflation reduces the comparability of multi-period financial statements and ratios even
    when the statements are adjusted for inflation. It is especially important to adjust growth
    rates for income and savings to real dollars. It is also useful to adjust nominal investment
    returns for inflation to determine real economic returns.
96   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                        15. Bart has a history of making large dollar purchases impulsively. As Bart’s plan-
                            ner, what could you do to help remedy this situation?
                              If a client does not have a history of saving money consistently, it is wise to develop a strat-
                              egy in which money the client receives in a check from his employer is directed into savings.
                              Similarly, if the client has a history of making large dollar purchases impulsively, it would be
                              wise to encourage investments in assets with early withdrawal penalties or those where with-
                              drawal is difficult. Withdrawal penalties or delays may discourage the client from making
                              such impulse purchases.
                                                          Chapter 4 | Personal Financial Statements (Preparation and Analysis)     97




   PROBLEMS AND SOLUTIONS
                           1. Given the following information, develop a beginning-of-the-year statement of
                              financial position.
                                                         Beginning date      January 1, 2009
                                                         End date            December 31, 2009
                                                         Client name         Frank and Lois Fox
                                                         Year                2009

                                                                                       Beginning       Ending       Income/Expenses
                                                                                        Balance        Balance       Amount (Yearly)
401(k)                                                                                                                    $750
401(k)—Frank                                                                                    $0       $1,500
403(b)                                                                                                                      $990
403(b) —Lois                                                                                   $0         $990
Auto loan                                                                                 $15,432       $10,436
Auto loan interest                                                                                                         $381
Auto loan principal                                                                                                       $4,996
Auto maintenance                                                                                                           $600
Automobile—Frank                                                                          $20,000       $18,000
Automobile—Lois                                                                            $5,750        $5,175
Automobile insurance premiums                                                                                             $2,124
Checking                                                                                  $10,000       $15,570
Child support                                                                                                             $2,400
Clothing                                                                                                                  $3,600
Credit card                                                                               $10,870       $10,417
Credit card payments interest                                                                                             $1,707
Credit card payments principal                                                                                             $453
Entertainment                                                                                                             $4,200
Federal income tax (W/H)                                                                                                  $7,018
FICA                                                                                                                      $4,431
Food                                                                                                                      $4,800
Furniture/household                                                                       $36,000       $34,000
Go-cart                                                                                        $0        $1,200
Homeowners insurance premiums                                                                                               $534
Jewelry                                                                                    $6,000        $6,100
Maid/child care                                                                                                           $4,800
Mortgage on residence                                                                     $72,960       $72,164
Mortgage payment interest                                                                                                 $5,808
Mortgage payment principal                                                                                                 $796
Personal residence                                                                        $85,000       $89,250
Property tax (principal residence)                                                                                        $850
Reinvestment in savings account/trust                                                                                    $5,675
Salary—Frank                                                                                                            $25,000
Salary—Lois                                                                                                             $33,000
Savings                                                                                   $13,500       $14,175
Savings account/trust fund interest                                                                                       $5,675
Trust fund                                                                              $100,000      $105,000
Tuition and education expenses                                                                                            $2,893
Utilities                                                                                                                 $2,100
Additional transactions:
Gift of bedroom furniture with a fair market value of $2,000 to Frank’s sister
401(k) match = 3% of income
Bought a go-cart for son for $1,200
Inheritance of $5,000 from Lois’s father
98   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition



                                                                       Frank and Lois Fox
                                                                 Statement of Financial Position
                                                                        January 01, 2009
                          Assets                                                      Liabilities and Net Worth
                          Cash/cash equivalents                                       Current liabilities
                          Checking                                  $10,000           Credit card                                    $10,870
                          Savings                                   $13,500           Mortgage loan                                      $796
                          Total cash/cash equiv.                    $23,500           Auto loan                                       $4,996
                                                                                      Total current liabilities                      $16,662
                          Invested assets
                          Trust fund                              $100,000
                          Total invested assets                   $100,000
                                                                                      Long-term liabilities
                          Personal use assets                                         Mortgage on residence                          $72,164
                          Personal residence                        $85,000           Auto loan                                      $10,436
                          Automobile—Frank                          $20,000           Total long-term liabilities                    $82,600
                          Automobile—Lois                             $5,750
                          Jewelry                                     $6,000
                          Furniture/household                       $36,000
                          Total personal use assets               $152,750            Total liabilities                              $99,262


                                                                                      Net worth                                    $176,988
                          Total assets                            $276,250            Total liabilities and net worth              $276,250
                          Note: Because the Foxes are not retiring their credit card debt within the year, the credit card liability may also
                          be recorded as a current and long-term liability in 2009.
                                Chapter 4 | Personal Financial Statements (Preparation and Analysis)   99


2. Use the data in Problem 1 to create a personal statement of cash flows.
                                          Frank and Lois Fox
                                   Personal Statement of Cash Flows
                                          For the Year 2009
           Income
           Salary
                    Salary—Frank                                        $25,000
                    Salary—Lois                                         $33,000      $58,000
           Investment income
                    Savings account/trust fund interest                               $5,675
                                               Total inflow                          $63,675
           Savings
                    Reinvestment in savings account/trust                 $5,675
                    401(k)                                                  $750
                    403(b)                                                  $990
                                               Total savings                          $7,415
           Available for expenses                                                    $56,260
           Expenses
           Ordinary living expenses
                    Food                                                  $4,800
                    Clothing                                              $3,600
                    Child support                                         $2,400
                    Entertainment                                         $4,200
                    Utilities                                             $2,100
                    Auto maintenance                                        $600
                    Maid/child care                                       $4,800
                    Total ordinary living expenses                                   $22,500
           Debt payments
                    Credit card payments principal                          $453
                    Credit card payments interest                         $1,707
                    Mortgage payment principal                              $796
                    Mortgage payment interest                             $5,808
                    Auto loan principal                                   $4,996
                    Auto loan interest                                      $381
                    Total debt payments                                              $14,141
           Insurance premiums
                    Automobile insurance premiums                         $2,124
                    Homeowners insurance premiums                           $534
                    Total insurance premiums                                          $2,658
           Tuition and education expenses                                             $2,893
           Taxes
                    Federal income tax (W/H)                              $7,018
                    FICA                                                  $4,431
                    Property tax (principal residence)                      $850
                    Total taxes                                                      $12,299
                    Total expenses                                                   $54,491
                    Discretionary cash flow                                           $1,769
100   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                          3. Use the data in Problem 1 to create a statement of net worth.

                                                                       Frank and Lois Fox
                                                               Statement of Changes in Net Worth
                                                             For the Year Ending December 31, 2009

                                        Additions to Net Worth
                                        Add (non-cash flow adjustments to net worth)
                                           Increases in assets:
                                                Appreciation of assets
                                                   Jewelry                                               $100
                                                   Residence                                           $4,250
                                                Purchase
                                                   Go-cart                                             $1,200
                                                Appreciation of investments
                                                   Trust fund                                          $5,000
                                                Increase of investments
                                                   401(k)—employee contribution                          $750
                                                   403(b)—employee contribution                          $990
                                                   401(k)—employer match                                 $750
                                           Decrease in liabilities (debt repayments):
                                                Mortgage                                                 $796
                                                Auto loan                                              $4,996
                                                Credit card debt                                         $453
                                        Total                                                         $19,285
                                        Reductions in net worth
                                        Less (non-cash flow adjustments to net worth)
                                           Decrease in assets:
                                                Depreciation of assets
                                                   Automobile—Frank                                   ($2,000)
                                                   Automobile—Lois                                     ($575)
                                                Gifts
                                                   Bedroom furniture to sister                        ($2,000)
                                        Total                                                         ($4,575)
                                        Non-cash flow change in net worth                             $14,710
                                        Beginning net worth                                          $176,988
                                        Changes from cash flows                                        $6,245
                                        Change from non-cash flows                                    $14,710
                                        Ending net worth                                             $197,943
                               Chapter 4 | Personal Financial Statements (Preparation and Analysis)       101


4. Use the data in Problem 1 to create an end-of-the-year statement of financial
   position.

                                         Frank and Lois Fox
                                   Statement of Financial Position
                                        December 31, 2009
Assets                                               Liabilities and net worth
Cash/cash equivalents                                Current liabilities
JT       Checking                   $15,570          JT        Credit card                            $10,417
JT       Savings                    $14,175          JT        Mortgage loan*                           $862
Total cash/cash equivalents         $29,745          H         Auto loan*                              $5,143
                                                     Total current liabilities                        $16,422
Invested assets
W        Trust fund                $105,000          Long-term liabilities
H        401(k)                       $1,500         JT        Mortgage on residence                  $71,302
W        403(b)                         $990         H          Auto loan                              $5,293
Total invested assets              $107,490          Total long-term liabilities                      $76,595


Personal use assets
JT       Personal residence         $89,250
H        Automobile—Frank           $18,000          Total liabilities                                $93,017
W        Automobile—Lois              $5,175
W        Jewelry                      $6,100
JT       Furniture/household        $34,000          Net worth                                   $197,943
JT       Go-cart                      $1,200
Total personal use assets          $153,725
Total assets                       $290,960          Total liabilities and net worth             $290,960
* See last page of solution


5. Use the results from the above problems to compute the following ratios for
   year-end:
     a. Emergency fund
     b. Current ratio
     c. Total debt to net worth
     d. Long-term debt to net worth
     e. Total debt to total assets
      f. Long-term debt to total assets
     g. Monthly housing costs to monthly gross income
     h. Monthly housing costs and other debt repayments to monthly gross income
      i. Savings ratio
      j. Discretionary cash flow plus savings to annual gross income
     k. Income on investments
      l. Return on investments
     m. Investment assets to annual gross income
102      Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                                6. Discuss the financial position of the Foxes as based on the ratios you calculated
                                   in the previous problem.

                                                            Financial Ratios
                                                          Frank and Lois Fox
                                                For the Year Ending December 31, 2009

                                                                 Current assets                      29,745
A. Emergency fund                                                                                                = 11.46 mos
                                                        Monthly nondiscretionary expenses
                                                                                     n             31,149 ÷ 12

                                                       (54,491 – 4,200 – 4,800 – 11,449 –
                                                                2,893 = 31,149)

                                                                   Current assets                    29,745
B. Current ratio                                                                                                 = 1.81
                                                                  Current liabilities                16,422

                                                                     Total debt                       93,017
C. Total debt to net worth                                                                                       = 0.47
                                                                     Net worth                       197,943

                                                                  Long-term debt                      76,595
D. Long-term debt to net worth                                                                                   = 0.39
                                                                    Net worth                        197,943

                                                                     Total debt                       93,017
E. Total debt to total assets                                                                                    = 0.32
                                                                     Total assets                    290,960

                                                                  Long-term debt                      76,595
F. Long-term debt to total assets                                                                                = 0.26
                                                                    Total assets                     290,960

G. Monthly housing costs to                        (mort pmt + prop tax + homeowners ins) ÷ 12     7,988 ÷ 12
                                                                                                                 = 0.13
   monthly gross income                                   (salary + interest income) ÷ 12          63,675 ÷ 12

H. Monthly housing costs and other                    (mort pmt + prop tax + homeowners ins +
   debt repayments to monthly gross                     auto pmt + credit card pmt) ÷ 12           15,525 ÷ 12
                                                                                                                 = 0.24
   income                                                   (salary + interest income) ÷ 12        63,675 ÷ 12

                                                                  Annual savings                     8,165
I. Savings ratio                                                                                                 = 0.13
                                                                Annual gross income                  63,675

                                                        (8,165 = 750 + 990 + 5,675 + 750
                                                                 employer match)

J. Discretionary cash flow +                                Income – expenses + savings              9,934
                                                                                                                 = 0.16
   savings to annual gross inc                                  Annual gross income                  63,675

                                                                                             e
                                                  Interest & dividends earned on invested assets      5,000
K. Income on investments                                                                                         = 0.05
                                                              Average invested assets                103,745

                                                      End invest – beg invest – (savings + gifts
L. Return on investments                                    applied to invested assets)                 0
                                                                                                                 = 0.00
                                                                           s
                                                             Average invested assets                 103,745

M. Investment assets to annual                                   Investment assets                   107,490
                                                                                                                 = 1.69
   gross income                                                    Gross income                       63,675


                                   Liquidity Ratios
                                   The Foxes’ emergency fund ratio is well above the 6-month target and may suggest that they
                                   have too many funds invested in highly liquid but poorly performing assets. Their current
                             Chapter 4 | Personal Financial Statements (Preparation and Analysis)      103


   ratio is in the target range of 1.0 to 2.0. From the statement of financial position, we can see
   that credit card debt makes up most of the current liabilities. Considering the high interest
   rates on credit card debt, the Foxes should think about using the excess cash to eliminate
   credit card debt and increase balances in higher performing investments.
   Debt Ratios and Debt Analysis
   All the debt ratios are quite low. If we compare long-term debt and total debt to the begin-
   ning of the year, we see that both liabilities have been reduced. Net worth and total assets
   have increased over that same period, which tells us that debt ratios have improved from the
   beginning of the year. Lower debt ratios indicate reduced financial risk—a good trend.
   The ratio of housing costs to gross income is 13%, well below the 28% benchmark. When
   we add in the debt repayments, the Foxes are at 24%, which is below the 36% benchmark.
   These ratios indicate that the Foxes are managing their debt well, and they have room to
   take on additional debt if the need arises.
   Performance Ratios
   The savings ratio and the discretionary cash flows plus savings-to-gross income ratio both indi-
   cate the Foxes are saving at the targeted rates. Comparing the ratios, we see that 3% of the
   Foxes’ gross income is discretionary cash flow. The income on investments ratio is 0.05, and
   the ROI is 0.00, which indicates no appreciation in value of the invested assets for the year.
   However, they did realize some income from those investments. Because these results are for only
   1 year, it is difficult to analyze the investments. The investment assets to gross income is 1.69,
   which is excellent if the Foxes are young and poor and if they are planning to retire in the next
   few years.
7. Prepare a vertical analysis of the ending statement of financial position and the
   personal statement of cash flows.

                                            Frank and Lois Fox
                                      Statement of Financial Position
                                           December 31, 2009
   Assets                                             Liabilities and net worth
   Cash/cash equivalents                              Current liabilities
   JT       Checking                      5.35%       JT        Credit card                         3.58%
   JT       Savings                       4.87%       JT        Mortgage loan                       0.30%
            Total cash/cash equiv.      10.22%        H         Auto loan                           1.77%
                                                                 Total current liabilities          5.65%
   Invested assets
   W        Trust fund                  36.09%        Long-term liabilities
   H        401(k)                        0.52%       JT        Mortgage on residence               24.51%
   W        403(b)                        0.34%       H         Auto loan                            .18%
              Total invested assets     36.95%               Total long-term liabilities            26.32%


   Personal use assets
   JT       Personal residence          30.67%
   H        Automobile—Frank              6.19%                             Total liabilities       31.97%
   W        Automobile—Lois               1.78%
   W        Jewelry                       2.10%
   JT       Furniture/household         11.69%                                  Net worth           68.03%
   JT       Go-cart                       0.41%
         Total personal use assets      52.83%
   Total assets                        100.00%        Total liabilities and net worth           100.00%
104   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                                                                        Frank and Lois Fox
                                                                 Personal Statement of Cash Flows
                                                                        For the Year 2009
                                Income
                                Salary
                                           Salary—Frank                                        39.26%
                                           Salary—Lois                                         51.83%   91.09%
                                Investment income
                                           Savings account/trust fund interest                           8.91%
                                           Total inflow                                                 100.00%
                                Savings
                                           Reinvestment in savings account/trust                8.91%
                                           401(k)                                               1.18%
                                           403(b)                                               1.55%
                                           Total savings                                                11.64%
                                Available for expenses                                                  88.36%
                                Expenses
                                Ordinary living expenses
                                           Food                                                 7.54%
                                           Clothing                                             5.65%
                                           Child support                                        3.77%
                                           Entertainment                                        6.60%
                                           Utilities                                            3.30%
                                           Auto maintenance                                     0.94%
                                           Maid/child care                                      7.54%
                                           Total ordinary living expenses                               35.34%
                                Debt payments
                                           Credit card payments principal                       0.71%
                                           Credit card payments interest                        2.68%
                                           Mortgage payment principal                           1.25%
                                           Mortgage payment interest                            9.12%
                                           Auto loan principal                                  7.85%
                                           Auto loan interest                                   0.60%
                                           Total debt payments                                          22.21%
                                Insurance premiums
                                           Automobile insurance premiums                        3.33%
                                           Homeowners insurance premiums                        0.84%
                                           Total insurance premiums                                      4.17%
                                Tuition and education expenses                                           4.54%
                                Taxes
                                           Federal income tax (W/H)                            11.02%
                                           FICA                                                 6.96%
                                           Property tax (principal residence)                   1.33%
                                           Total taxes                                                  19.31%
                                           Total expenses                                               85.57%
                                           Discretionary cash flow                                       2.78%
                            Chapter 4 | Personal Financial Statements (Preparation and Analysis)   105


8. Lisa recently bought a house for $150,000 using a fixed 30-year home loan with
   a 5% interest rate. She used 20% of the amount towards the down payment and
   paid the $5,000 in closing costs out of pocket. How much mortgage interest can
   Lisa expect to pay over the course of this loan?
   Amount of the loan: $120,000 (less the 20% down payment)
   Number of payments: 360
   Monthly payment: $644.19
   Total payments: $231,906.97 (There may be a slight discrepancy here.)
   Total interest payment: $111,906.97 ($120,000 − $231,906.97)
   Lisa will pay $111,906.97 in interest over the course of this loan.
   * We have provided model solutions for this section. Please note that your students may
   not get these exact answers. Creating these financial statements is very difficult, and
   many students have difficulty. If your class has not covered time value of money, then
   they probably will not be able to get the new statement of financial position figures for
   current versus long-term liabilities. You may want to provide the new figures.
   How to get auto loan on ending statement of financial position:

                                PMT = 381 + 4,996 = 5,377
                                  Int = PV           = 15,432
                                             FV      = (10,436)
                                             PMT     = (5,377) ÷ 12
                                             n       = 12
                                             Solve i = 0.2414

                                  Year 2:
                                         PV          = 10,436
                                         PMT         = (5,377) ÷ 12
                                         n           = 12
                                         i           = 0.2414
                                         Solve FV = 5,293

                               10,436
                               (5,293)
                                5,143        Year 2 current liability
   How to get mortgage loan on ending statement of financial position:

                                 PMT = 5,808 + 796 = 6,604
                                   Int = PV          = 72,960
                                             FV      = (72,164)
                                             PMT     = (6,604) ÷ 12
                                             n       = 12
                                             Solve i = 0.6667
106   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition



                                                                 Year 2:
                                                                        PV             = 72,164
                                                                        PMT            = (6,604) ÷ 12
                                                                        n              = 12
                                                                        i              = 0.6667
                                                                        Solve FV = 71,302

                                                                     72,164
                                                                    (71,302)
                                                                       862


                                                                    6,604 – 862 = 5,742 interest
                                Chapter 5 | Establishing Financial Direction: The Financial Planning Process   119




DISCUSSION QUESTIONS AND SOLUTIONS

        1. What are the six steps of the financial planning process?

           Step 1—Develop the client-planner relationship.

           Step 2—Gather client data and determine goals and expectations.

           Step 3—Determine the client's financial status.

           Step 4—Develop and present the financial plan.

           Step 5—Implement the financial plan.

           Step 6—Monitor the financial plan.
        2. What is the definition of a financial mission?
           A financial mission is a broad and enduring statement that identifies the client’s long-term
           purpose for wanting a financial plan.
        3. What are the three main activities that take place during Step 2 of the financial
           planning process: Gather client data and define goals and objectives?
           The three main activities that take place during Step 2 of the financial planning process are:
           ■ identify relevant environmental information;
           ■ establish financial goals; and
           ■ develop financial objectives.
        4. What are the most common goals developed during the financial planning
           process?
           The most common financial goals can be divided into five categories:
           ■ Insurance Planning: The goal is to mitigate the risks of catastrophic losses to persons,
             property, and liability by maintaining appropriate insurance coverage while paying effi-
             cient premiums.
           ■ Retirement Planning: The goal is to adequately provide inflation-protected retirement
             income at an appropriate age for full life expectancy, conservatively estimated.
           ■ Estate Planning: The goal is to have a proper estate plan consistent with transfer goals.
           ■ Tax Planning: The goal is to arrange income tax affairs so as to mitigate income tax
             liability and take advantage of incentives in the tax law as appropriate.
           ■ Investment Planning: The goal is to save and invest so as to accumulate capital for retire-
             ment, wealth transfer, and other expenditure objectives, such as the purchase of personal
             property, education, lump-sum payments, and emergencies.
        5. How do financial goals and financial objectives differ?
           Goals are high-level statements of desires that may be for either the short or long term.
           Objectives are more specific than goals. Several objectives may be developed for each goal
           category and should include time and measurement attributes when appropriate.
120   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                           6. Why must a financial planner keep abreast of the external environment?
                               External environmental changes may have an impact on clients’ goals and objectives. The
                               planner must keep abreast of external environmental changes so the financial plan can be
                               modified to take advantages of opportunities and to minimize threats.
                           7. How does client subjectivity affect the establishment of financial objectives?
                               When establishing financial objectives with a client, subjectivity and strong desires can
                               become an issue when distinguishing between a want and a need. Occasionally, a client
                               believes an objective must be accomplished (is a need) simply because the client has a
                               strong desire to achieve that objective.
                           8. What is the difference between need and want objectives?
                               A need objective is an objective that must be implemented to achieve the financial mission
                               or to comply with law. A want objective is desired but is not a critical factor in reaching the
                               mission.
                           9. What questions can be asked of financial objectives to determine whether the
                              objective is a need or a want objective?
                               Asking both of the following questions can determine whether an objective is a need or a
                               want objective.
                               ■ Is this objective necessary to accomplish the financial mission?
                               ■ Does the law require that this objective be implemented?
                               If the answer to either of these questions is yes, the objective is a need. If the answer to both
                               of these questions is no, the objective is a want.
                         10. What does the acronym SWOT stand for?
                               SWOT stands for strengths, weaknesses, opportunities, and threats.
                         11. During Step 3 of the financial planning process—Determine the client's financial
                             status—how can a SWOT analysis be useful to a financial planner?
                               A SWOT analysis helps the planner convert several bits of relevant information into an
                               understandable format. It helps the planner understand how the internal and external envi-
                               ronments impact the client’s situation.
                         12. What must be considered when formulating strategy alternatives?
                               When formulating strategy alternatives, the planner must consider:
                               ■ the client’s financial situation;
                               ■ the external environment and its affect on the client;
                               ■ the client’s internal data and life cycle positioning; and
                               ■ the client’s mission, goals, and objectives.
                         13. What are common methods to increase cash inflow or reduce cash outflow?
                               Common sources to increase cash inflows or reduce cash outflows include the following:
                               ■ Cutting discretionary expenses such as entertainment, vacations, utilities, and charitable
                                 contributions
                               ■ Refinancing mortgages to reduce payment or decrease the debt term
                               ■ Raising insurance deductibles to reduce premiums
                               ■ Making use of tax-advantaged savings
                               ■ Obtaining additional income from employment
                          Chapter 5 | Establishing Financial Direction: The Financial Planning Process   121


14. What should be considered when selecting strategies to implement?
    When selecting strategies to implement, the planner and the client should consider how the
    strategy might change the client’s:
    ■ current consumption and savings behavior;
    ■ existing savings rate;
    ■ time horizon; and
    ■ asset allocation.
    While considering these issues, the client should answer the following questions with the
    planner’s assistance.
    ■ How easy will it be to implement this strategy?
    ■ How committed am I to implementing this strategy, considering the required sacrifices?
15. How can the planner improve the probability of successful implementation of
    strategies?
    The financial planner can improve the probability of successful implementation by ensur-
    ing that the client has a detailed understanding of the current strategy, can measure progress
    toward the attainment of objectives, and, through periodic monitoring, can adjust the plan
    as necessary. The planner can be reasonably assured that the client has a detailed under-
    standing of the plan if the client actively participates in the goal and objectives develop-
    ment and in strategy selection.
16. How often should a financial plan be monitored?
    Quarterly monitoring is recommended along with annual face-to-face meetings with the cli-
    ent. However, because internal and external circumstances change and plans do not always
    work as expected, additional periodic monitoring is also recommended.
122    Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition




      EXERCISES AND SOLUTIONS
                            1. Assume Nicholas and Amy contacted you, a financial planner, to assist them in
                               saving for a car, the children’s education, and a boat. Which thinking phase are
                               they probably demonstrating?
                                They are probably consumed in the Paradoxical Thinking phase characterized by multiple,
                                potentially conflicting goals.
                            2. What would you do if a client came to you insisting that his financial mission
                               was to buy a 1965 Mustang?
                                As a financial planner, part of your responsibility is educating the client. This client needs
                                to learn that a mission is a broad and enduring statement of financial desire. Furthermore,
                                buying a Mustang is only one objective under the goal category of Capital Accumulation
                                for Other Goals. The client must become aware that he may have many other unarticulated
                                objectives that conflict with his desire to purchase the Mustang.
                            3. If you were working with a client to distinguish between a want and a need
                               objective and the client wanted to categorize buying a vacation home as a need,
                               what would you do?
                                The financial planner should refocus the client on the financial mission and then ask the
                                following questions of that objective: Is the objective necessary to accomplish the mission?
                                Does the law require that this objective be implemented? If the answer to both of these
                                questions is no, the objective is a want.
                            4. What would you say or do to help clients understand the difference between a
                               goal and an objective?
                                The financial planner can use the Client/Planner Worksheet for Establishing Financial
                                Direction to demonstrate the difference between a goal and an objective. It is important for
                                the client to realize that objectives are more specific than goals and generally can be catego-
                                rized under a goal. Usually, the clients are more aware of their financial objectives than their
                                financial goals. The financial planner should identify all of the common goals to help ensure
                                that all need objectives are identified.
                            5. What should a planner and a client take into consideration when determining
                               strategies to implement?
                                When selecting strategies to implement, the planner and the client should consider how the
                                strategy might change the client’s:
                                ■ current consumption and savings behavior;
                                ■ existing savings rate;
                                ■ time horizon; and
                                ■ asset allocation.
                                While considering these issues, the client should answer the following questions with the
                                planner’s assistance.
                                 1. How easy will it be to implement this strategy?
                                 2. How committed am I to implementing this strategy, considering the required sacrifices?
                                Chapter 5 | Establishing Financial Direction: The Financial Planning Process   123




PROBLEMS AND SOLUTIONS
        1. Assume your client, Alex, has multiple objectives requiring monthly cash flows
           of $400, $250, $150, $750, and $325, respectively. Also assume that his cur-
           rent discretionary cash flow per month is $380.
          A. What technique would you use to bring Alex into economic reality?
           We recommend the use of a Discretionary Cash Flow Statement after implementing need
           objectives.
           B. How would you distinguish between need objectives and want objectives?
           Consider the following to determine whether an objective is a need or a want objective.
            1. Is this objective necessary to accomplish the financial mission?
            2. Does the law require that this objective be implemented?
           If the answer to either of these questions is yes, the objective is a need. If the answer to both
           of these questions is no, the objective is a want.
           C. Where might you look for additional available cash flows to meet Alex's
              objectives?
           ■ Cutting discretionary expenses such as entertainment, vacations, utilities, and charitable
             contributions
           ■ Refinancing mortgages to reduce payment or decrease the debt term
           ■ Raising insurance deductibles to reduce premiums
           ■ Making use of tax-advantaged savings
           ■ Obtaining additional income from employment
        2. Assume Ben and Sarah have hired you as their financial planner. Upon brief
           investigation, you collect the following information. The couple has been married
           for 5 years and have no children. They take expensive vacations several times a
           year. Both have good jobs and both save the maximum allowed in their Section
           401(k) plans. The mortgage on their house is at 10.3%. The current mortgage
           rate is 8.15%. Their credit card balance has been approximately $1,500 for some
           time, and they make minimum payments each month. The couple has a monthly
           discretionary cash flow deficit of $98. What would be your recommendations to
           increase their monthly discretionary cash flow?
           Based on the limited information above, our recommendation would be for the couple to
           refinance their home and pay off their credit cards. (Before considering refinancing, how-
           ever, they should have the intent to remain in the residence.)
           Other recommendations may vary depending on a host of unknowns such as their current
           level of retirement savings and investments, their health, their insurance, the stability of
           their jobs, the health and age of their parents, and whether they plan on having children.
144    Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition




      DISCUSSION QUESTIONS AND SOLUTIONS

                           1. What is the time value of money (TVM) concept and why is it so important in
                              financial planning?
                                The concept of time value of money is that money received today is worth more than the
                                same amount of money received sometime in the future. Comparisons of dollars received
                                and paid at the same point in time are necessary to solve many financial planning problems
                                and to make sound financial decisions. Thus, time value of money calculations are funda-
                                mental to financial planning. Time value of money calculations are one of the tools that
                                allow financial planners to properly plan for their client’s goals and objectives.
                           2. What are the important questions in financial planning that can be answered
                              using time value of money concepts?
                                ■ If I have a certain dollar amount today, how much will it be worth at some time in the
                                  future if it is invested at a certain rate of earnings (interest)?
                                ■ If I invested a certain dollar amount on a regular interval basis and at a constant earnings
                                  rate, how much would I accumulate at some future date?
                                ■ If I wanted to save for the college education of my children, how much would I need to
                                  save starting today on a regular interval basis to pay for that education?
                                ■ If I wanted to pay off my house mortgage early, how many dollars would I need to add to
                                  each monthly payment?
                                ■ What is the present value of my expected Social Security retirement benefits?
                                ■ How much investment capital will I need to retire at a particular age and still maintain
                                  my preretirement lifestyle?
                           3. What is meant by present value and future value, and how are these two
                              concepts used in the calculation of compound interest?
                                Future value is the future dollar amount to which a sum certain today will increase com-
                                pounded at a defined interest rate over a period of time. Present value is the current dollar
                                value of a future sum discounted at a defined interest rate over a period of time. Future value
                                is calculated by a process called compounding. Present value is calculated by a process called
                                discounting. The initial mathematical relationship between the present value and the future
                                value is expressed as:
                                                                            FV = PV(1 + i)

                           4. What are the basic tools used in TVM analysis?
                                Mathematical equations, cash flow time lines, time value of money tables, financial calcula-
                                tors, cash flow computer software, and accumulation schedules are considered basic TVM
                                tools. Amortization tables and the Rule of 72 are additional tools used by financial planners.
                           5. How are TVM tables computed?
                                Time value of money tables represent the various values for combinations of i and n. The
                                amounts given in the table represent the value of a dollar deposited today (received in the
                                future) and compounded (discounted) at a defined rate (i) for a defined period (n).
                                                           Chapter 6 | Time Value of Money     145


 6. What is the difference between the future value of an ordinary annuity (FVOA)
    and the present value of an ordinary annuity (PVOA)?
    The future value of an ordinary annuity is the future amount to which a series of deposits of
    equal size will amount when deposited over a definite number of equal interval time periods
    based on a defined interest rate and deposited at the end of the period. The present value of
    an ordinary annuity is the value today of a series of equal payments made at the end of each
    period for a finite number of periods.
 7. What is the difference between the future value of an annuity due (FVAD) and
    the present value of an annuity due (PVAD)?
    The future value of an annuity due is the future value to which a series of deposits of equal
    size will amount when deposited over a definite number of equal interval periods based on a
    defined interest rate and deposited at the beginning of the period. The present value of an
    annuity due is the value today of a series of equal payments made at the beginning of each
    period for a finite number of periods.
 8. When would you use an ordinary annuity or an annuity due in financial
    planning?
    The ordinary annuity is common in investments and in debt repayment. It is sometimes
    referred to as a payment made in arrears. An annuity due calculation is commonly used in
    educational funding, retirement funding, or capital needs analysis when payments or invest-
    ments are made at the beginning of the period.
 9. What are some TVM concepts other than annuities?
    Some of the other common time value of money applications are uneven cash flows, com-
    bining sum certains with annuities, net present value (NPV), internal rate of return (IRR),
    yield to maturity (YTM), solving for term, selecting the interest rate, serial payments, perpe-
    tuities, educational funding, and capital needs analysis for retirement.
10. How do unequal cash flows affect the future value of an investment?
    Investment returns or deposits are not always single interval deposits or equal payments. The
    uneven cash flow keys of a financial calculator can be used to solve this type of problem.
11. How do net present value (NPV) and internal rate of return (IRR) differ in
    financial planning calculations?
    The NPV model and the IRR model make different assumptions about the reinvestment rate
    of cash flows received during the period of investment. The NPV assumes the reinvestment
    rate to be the weighted average cost of capital or required return of the investor. The IRR
    calculation assumes the reinvestment rate equals the IRR. Therefore, the NPV is considered
    a superior model to IRR when comparing investment projects of unequal lives.
12. What is yield to maturity (YTM) and how is it used to determine a bond’s
    earnings?
    Yield to maturity (YTM) is determined by solving for the earnings rate that equates the cur-
    rent market price of the bond to the cash flows from the bond. It is the application of the
    IRR model to bond investments.
13. How is the concept of solving for term given the other variables useful in debt
    management?
    Solving for term (N) determines the period necessary (in months, quarters, or years) to save
    or pay at a given rate to accomplish a stated goal, if you save or pay at a given rate. This
    analysis is particularly useful in debt management, such as determining the:
    ■ term to pay off student loans;
    ■ term to pay off a mortgage;
146   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                               ■ term to save for college education; and
                               ■ term to save for a special purchase (car, home, vacation).
                         14. What alternative rate choices exist when selecting the rate of interest for accu-
                             mulating or discounting?
                               The choices include the expected rate of earnings for a particular investment, the client’s
                               opportunity cost, the riskless rate, the consumer price index (CPI) for some future expen-
                               ditures, the specific inflation rate for particular services (educational and medical), or the
                               real rate of return that accommodates both the nominal earnings rate and some measure of
                               inflation.
                         15. How is the real return of an investment affected by the inflation rate?
                               Real economic returns reflect the earnings from an investment above the inflation rate.
                               However, simply subtracting the rate of inflation from the nominal earnings rate will not
                               yield the real economic rate of return. Real economic returns must be calculated by using
                               the following formula:

                                                                 (1 + the nominal rate) 
                                                                 (1 + the inflation rate) − 1 × 100
                                                                                             

                         16. How do serial payments affect the future value of an investment?
                               A serial payment is a payment that increases at a constant rate (usually inflation) on an
                               annual basis. There are situations when investors are more comfortable increasing payments
                               or deposits on an annual basis because the investor is expecting increases in income with
                               which to make those increasing payments (examples are investment deposits, life insurance
                               premiums, educational needs, retirement needs, or any lump-sum future expenditure). Serial
                               payments differ from fixed annuity payments (both ordinary annuities and annuities due)
                               because the payments are increasing at a constant rate. The result is that the initial serial
                               payment will be less than a fixed annuity payment but the last deposit or payment will be
                               greater than a fixed annuity payment.
                         17. What are perpetuities and how do they affect financial planning?
                               A perpetuity is a payment cash flow stream that remains constant indefinitely. Preferred
                               stock is an example of a perpetuity.
                         18. How can amortization tables and the Rule of 72 assist in solving present TVM
                             problems?
                               Amortization tables are primarily used to illustrate the amortization of debt. Initially, a table
                               is created with the beginning balance of debt, a level payment, the amount of the payment
                               that is interest, the amount of the payment that is used to reduce the principal indebtedness,
                               and the ending balance of the indebtedness for each year. The common usage for amorti-
                               zation tables is for mortgages, but it can be used to illustrate any indebtedness repayment
                               schedule. The Rule of 72 is used by financial planners to estimate the time that it takes to
                               double the value of an investment where the earnings rate is known. Alternatively, the Rule
                               of 72 will estimate the earnings rate necessary to double an investment value if the time is
                               known. The Rule of 72 states that if you know a rate of return, you can determine the peri-
                               od of time it takes to double the value of the investment by dividing 72 by the interest rate.
                                                                   Chapter 6 | Time Value of Money   147




EXERCISES AND SOLUTIONS
        1. Calculate the present value of $10,000 to be received in exactly 10 years,
           assuming an annual interest rate of 9%.

                                            FV       = $10,000
                                            i        = 9
                                            n        = 10
                                            PMT = $0
                                            PV       = ($4,224.1081)

        2. Calculate the future value of $10,000 invested for 10 years, assuming an annual
           interest rate of 9%.
                                                PV   = ($10,000)
                                                i    = 9
                                                n    = 10
                                                PMT = $0
                                                FV   = $23,673.6368
        3. Calculate the present value of an ordinary annuity of $5,000 received annually
           for 10 years, assuming a discount rate of 9%.

                                        PMTOA = $5,000
                                        i            = 9
                                        n            = 10
                                        FV           = $0
                                        PV           = ($32,088.2885)

        4. Calculate the present value of an annuity of $5,000 received annually that
           begins today and continues for 10 years, assuming a discount rate of 9%.

                                        PMTAD = $5,000
                                        i            = 9
                                        n            = 10
                                        FV           = $0
                                        PV           = ($34,976.2345)

           Note: 32,088.2885 × 1.09 = 34,976.2345
        5. Calculate the future value of an ordinary annuity of $5,000 received for
           10 years, assuming an earnings rate of 9%.

                                        PV           = $0
                                        PMTOA = $5,000
                                        i            = 9
                                        n            = 10
                                        FV           = ($75,964.6486)
148          Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                                 6. Calculate the future value of an annual annuity of $5,000 beginning today and
                                    continuing for 10 years, assuming an earnings rate of 9%.

                                                                            PV        = $0
                                                                            PMTAD = $5,000
                                                                            i         = 9
                                                                            n         = 10
                                                                            FV        = ($82,801.4670)

                                      Note: 75,964.6486 × 1.09 = 82,801.4670
                                 7. Mike borrows $240,000 at 8% for a mortgage for 15 years. Prepare an annual
                                    amortization table assuming the first payment is due January 30, 2010, exactly
                                    30 days after the loan.

                                                                            PV        = $240,000
                                                                            i         = 0.6667 (8 ÷ 12)
                                                                            n         = 180 (15 × 12)
                                                                            FV        = $0
                                                                            PMTOA = ($2,293.5650)

      Year       Beginning Balance             Payments           Interest Amortization       Principal Reduction   End Balance of Debt
       1           $240,000.0000            $27,522.7800              $18,887.9471                $8,634.8329         $231,365.1671
       2           $231,365.1671            $27,522.7800              $18,171.2602                $9,351.5198         $222,013.6472
       3           $222,013.6472            $27,522.7800              $17,395.0887              $10,127.6913          $211,885.9559
       4           $211,885.9559            $27,522.7800              $16,554.4953              $10,968.2847          $200,917.6712
       5           $200,917.6712            $27,522.7800              $15,644.1330              $11,878.6470          $189,039.0242
       6           $189,039.0242            $27,522.7800              $14,658.2112              $12,864.5688          $176,174.4554
       7           $176,174.4554            $27,522.7800              $13,590.4583              $13,932.3217          $162,242.1337
       8           $162,242.1337            $27,522.7800              $12,434.0825              $15,088.6975          $147,153.4362
       9           $147,153.4362            $27,522.7800              $11,181.7281              $16,341.0519          $130,812.3843
      10           $130,812.3843            $27,522.7800                $9,825.4288             $17,697.3512          $113,115.0331
      11           $113,115.0331            $27,522.7800                $8,356.5574             $19,166.2226           $93,948.8105
      12            $93,948.8105            $27,522.7800                $6,765.7704             $20,757.0096           $73,191.8009
      13            $73,191.8009            $27,522.7800                $5,042.9488             $22,479.8312           $50,711.9697
      14            $50,711.9697            $27,522.7800                $3,177.1339             $24,345.6461           $26,366.3236
      15            $26,366.3236            $27,522.7800                $1,156.4573             $26,366.3227                $0.0008
                                      Note: The interest was calculated on a monthly basis and then put into the annual table.
                                 8. Joan invested $5,000 in an interest-bearing promissory note earning an 8%
                                    annual rate of interest compounded monthly. How much will the note be worth
                                    at the end of 5 years, assuming all interest is reinvested at the 8% rate?
                                                               Chapter 6 | Time Value of Money   149


    Time Value of Money—Future Value/Annual Compounding

                                PV            = ($5,000)
                                i             = 0.6667 (8 ÷ 12)
                                n             = 60 (5 × 12)
                                PMT = $0
                                FV            = $7,449.2285

 9. Callie expects to receive $50,000 in 2 years. Her opportunity cost is 10% com-
    pounded monthly. What is the sum worth to Callie today?
    Time Value of Money—Present Value/Monthly Compounding

                                    FV         = $50,000
                                    i          = 0.8333 (10 ÷ 12)
                                    n          = 24 (2 × 12)
                                    PMT = $0
                                    PV         = ($40,970.4772)

10. Lola purchased a zero-coupon bond 9 years ago for $600. If the bond matures
    today and the face value is $1,000, what is the average annual compound rate of
    return (calculated semiannually) that Lola realized on her investment?
    Time Value of Money—Interest Rates

                      PV    = ($600)
                      FV    = $1,000
                      n     = 18 (9 × 2)
                      PMT = $0
                      i     = 2.8786%
                      Annual rate of return = 2.8786 × 2 = 5.7571%

11. Today Evan put all of his cash into an account earning an annual interest rate of
    10%. Assuming he makes no withdrawals or additions into this account, approx-
    imately how many years must Evan wait to double his money? Use the Rule of
    72 to determine the answer.
                                             72 ÷ 10 = 7.2 years
12. Anthony has been investing $1,500 at the end of each year for the past 12
    years. How much has accumulated, assuming he has earned 8% compounded
    annually on his investment?
    Time Value of Money—Future Value of an Ordinary Annuity

                                        PV       = $0
                                        PMTOA = ($1,500)
                                        i        = 8
                                        n        = 12
                                        FV       = $28,465.6897
150   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                         13. Dennis has been dollar cost averaging in a mutual fund by investing $1,000
                             at the beginning of every quarter for the past 5 years. He has been earning an
                             average annual compound return of 11% compounded quarterly on this invest-
                             ment. How much is the fund worth today?
                               Time Value of Money—Future Value of an Annuity Due Compounded Quarterly

                                                                         PV    = $0
                                                                         PMTAD = ($1,000)
                                                                         i     = 2.75 (11 ÷ 4)
                                                                         n     = 20 (5 × 4)
                                                                         FV    = $26,917.8259

                         14. Casey, injured in an automobile accident, won a judgment that provides him
                             $2,500 at the end of each 6-month period over the next 3 years. If the escrow
                             account that holds Casey’s settlement award earns an average annual rate of 10%
                             compounded semiannually, how much was the defendant initially required to pay
                             Casey to compensate him for his injuries?
                               Time Value of Money—Present Value of an Ordinary Annuity Compounded Semiannually

                                                                         PMTOA = ($2,500)
                                                                         i      = 5.00 (10 ÷ 2)
                                                                         n      = 6 (3 × 2)
                                                                         FV     = $0
                                                                         PV     = $12,689.2302

                         15. Stacey wants to withdraw $3,000 at the beginning of each year for the next
                             5 years. She expects to earn 8% compounded annually on her investment. What
                             lump sum should Stacey deposit today?
                               Time Value of Money—Present Value of an Annuity Due Compounded Annually

                                                                         PMTAD = ($3,000)
                                                                         i      = 8
                                                                         n      = 5
                                                                         FV     = $0
                                                                         PV     = $12,936.3805

                         16. Gary wants to purchase a beach condo in 7 years for $100,000. What periodic
                             payment should he invest at the beginning of each quarter to attain the goal if he
                             can earn 11% annual interest, compounded quarterly on investments?
                               Time Value of Money—Payment Calculation for Annuity Due with Quarterly Compounding

                                                                     FV        = $100,000
                                                                     i         = 2.75 (11 ÷ 4)
                                                                     n         = 28 (7 × 4)
                                                                     PV        = $0
                                                                     PMTAD = ($2,353.0296)
                                                          Chapter 6 | Time Value of Money   151


17. Ann purchased a car for $25,000. She is financing the auto at a 10% annual
    interest rate, compounded monthly for 4 years. What payment is required at the
    end of each month to finance Ann’s car?
    Time Value of Money—Payment Calculation for an Ordinary Annuity Using Monthly
    Compounding

                                   PV         = $25,000
                                   i          = 0.8333 (10 ÷ 12)
                                   n          = 48 (4 × 12)
                                   FV         = $0
                                   PMTOA = ($634.0646)

18. Josh purchased a house for $215,000 with a down payment of 20%. If he finances
    the balance at 10% over 30 years, how much will his monthly payment be?
    Mortgage Payment Calculation

                             n          = 360 (30 × 12)
                             i          = 0.8333 (10 ÷ 12)
                             PV         = $172,000 ($215,000 × .80)
                             FV         = 0
                             PMTOA = ($1,509.4231)

19. Chase purchased a house for $300,000. He put 20% down and financed the
    remaining amount over 30 years at 8%. How much interest will be paid over
    the life of the loan assuming he pays the loan as agreed? (Round to the nearest
    dollar.)
    Mortgage Interest

                    PV       = $240,000 (300,000 × .80)
                    i        = 0.6667 (8 ÷ 12)
                    n        = 360 (30 × 12)
                    PMTOA = ($1,761.0350)
                  Total Payments       $633,974.40 ($1,761.04 rounded × 360)
                  Less Principal        240,000.00
                  Total Interest       $393,974.40
152    Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition




      PROBLEMS AND SOLUTIONS
                           1. Lucy wants to give her son $80,000 on his wedding day in 4 years. How much
                              should she invest today at an annual interest rate of 9.5% compounded annually
                              to have $80,000 in 4 years? Alternatively, how much would she need to invest
                              today if she could have her interest compounded monthly? Explain which inter-
                              est option would be most beneficial to Lucy.

                                                                 Compounded Yearly        Compounded Monthly
                                                  FV        =    $80,000                  $80,000
                                                  PMT =          0                        0
                                                  n         =    4                        48 (4 × 12)
                                                  i         =    9.5                      0.7917 (9.5 ÷ 12)
                                                  PV        =    ($55,645.9435)           ($54,790.8336)

                                The best option for Lucy would be the monthly compounding because she could deposit
                                fewer funds today, yet still receive the same future amount.
                           2. Rachel, who just turned 18, deposits a $15,000 gift into an interest-bearing
                              account earning a 7.5% annual rate of interest. How much will she have in the
                              account when she retires at age 60, assuming all interest is reinvested at the
                              7.5% rate? If Rachel decided she only needed $300,000 at retirement, could she
                              retire at 59? Explain.

                                                                        Retire at 60      Retire at 59
                                                        PV           = ($15,000)          ($15,000)
                                                        PMT = 0                           0
                                                        n            = 42 (60 – 18)       41 (59 – 18)
                                                        i            = 7.5                7.5
                                                        FV           = $312,785.6049      $290,963.3534

                                Rachel could not retire at 59 because she would have only $290,963.3534 available, which
                                would be $9,036.6466 ($300,000.0000 – $290,963.3534) short of her goal.
                           3. Kerri won the lottery today. She has two options. She can receive $30,000 at
                              the end of each year for the next 15 years or take a lump-sum distribution of
                              $200,000. Her opportunity cost is 12% compounded annually. Based on present
                              values, which option should she choose?
                                PVOA

                                                                             Payments         Lump Sum
                                                            FV          = 0
                                                            PMTOA = ($30,000)
                                                            n           = 15
                                                            i           = 12
                                                            PV          = $204,325.9347       $200,000

                                Based on present values, Kerri would be better off taking the annual payments because her
                                net present value would be greater by $4,325.9347.
                                                                Chapter 6 | Time Value of Money   153


4. Darrin wants to donate $8,000 to his church at the beginning of each year for
   the next 20 years. What lump sum should Darrin deposit today if he expects to
   earn 11% compounded annually on his investment? Alternatively, how much
   should he deposit if he wants to have $50,000 left at the end of the 20 years?
   PVAD

                                     No Remaining Balance             Remaining Balance
               FV           =        0                                $50,000
               PMTAD =               $8,000                           $8,000
               n            =        20                               20
               i            =        11                               11
               PV           =        ($70,714.3537)                   ($76,916.0490)

5. James deposited $800 at the end of the past 16 years to purchase his grand-
   daughter, Kali, a car. James earned 8% interest compounded annually on his
   investment. If the car Kali chooses costs $22,999, would she have enough
   money in the account to purchase the vehicle? What would be the deficit or
   surplus?
   FVOA

                                Account Balance             Surplus/Deficit
          PV            =       0                           $ 24,259.4264
          PMTOA         =       ($800)                      $(22,999.0000)
          n             =       16                          $ 1,260.4264            Surplus
          i             =       8
          FV            =       $24,259.4264

6. Brenda has been investing $150 at the beginning of each month for the past 20
   years. How much has she accumulated, assuming she has earned an 11% annual
   return compounded monthly on her investment? If instead of earning 11%,
   Brenda was only able to earn 10% (compounded monthly), how much would her
   payments need to be to have the same accumulated amount?
   FVAD

                                         11% Interest             10% Interest
                   PV           =        0                        0
                   PMTAD        =        ($150)                   ($171.1329)
                   n            =        240 (20 × 12)            240 (20 × 12)
                   i            =        0.9167 (11 ÷ 12)         0.8333 (10 ÷ 12)
                   FV           =        $131,035.9580            $131,035.9580
154   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                          7. Kenneth took out a loan today to purchase a boat for $160,000. He will repay
                             the loan over a 30-year period at 9% interest (with payments occurring monthly).
                             What will be his remaining principal balance at the end of the first year?

                                 Amortization Tables
                                            Beginning                              Interest      Principal    End Balance
                        Payment              Balance           Payments          Amortization   Reduction       of Debt
                            1             160,000.0000        1,287.3962          1,200.0000      87.3962    159,912.6038
                            2             159,912.6038        1,287.3962          1,199.3445      88.0517    159,824.5521
                            3             159,824.5521        1,287.3962          1,198.6841      88.7121    159,735.8401
                            4             159,735.8401        1,287.3962          1,198.0188      89.3774    159,646.4627
                            5             159,646.4627        1,287.3962          1,197.3485      90.0477    159,556.4149
                            6             159,556.4149        1,287.3962          1,196.6731      90.7231    159,465.6919
                            7             159,465.6919        1,287.3962          1,195.9927      91.4035    159,374.2883
                            8             159,374.2883        1,287.3962          1,195.3072      92.0890    159,282.1993
                            9             159,282.1993        1,287.3962          1,194.6165      92.7797    159,189.4196
                            10            159,189.4196        1,287.3962          1,193.9206      93.4756    159,095.9440
                            11            159,095.9440        1,287.3962          1,193.2196      94.1766    159,001.7674
                            12            159,001.7674        1,287.3962          1,192.5133      94.8829    158,906.8845
                                                                                14,355.6389     1,093.1155
                       Remaining principal = $160,000 − $1,093.1155 = $158,906.8846


                          8. Cody estimates his opportunity cost on investments at 9% compounded annually.
                             Which of the following is the best investment opportunity?
                                 ■ Option A—To receive $100,000 today
                                 ■ Option B—To receive $400,000 at the end of 15 years
                                 ■ Option C—To receive $1,500 at the end of each month for 10 years com-
                                            pounded monthly
                                 ■ Option D—To receive $75,000 in 5 years and $100,000 5 years later
                                 ■ Option E—To receive $75,000 in 5 years and $175,000 10 years later
                                 Time Value of Money—Present Value Analysis of Alternatives
                                 Option A:
                                     PV = $100,000
                                 Option B:
                                      FV       =   $400,000
                                      i        =   9
                                      n        =   15
                                      PMT =        $0
                                      PV       =   ($109,815.2165)
                                                                Chapter 6 | Time Value of Money   155


    Option C:

         PMT    =    $1,500
         i      =    .75 (9 ÷ 12)
         n      =    120 (10 × 12)
         FV     =    $0
         PVOA   =    ($118,412.5390)

    Option D:

         FV     = $75,000                        FV    =    $100,000
         i      = 9                              i     =    9
         n      = 5                              n     =    10
         PMT    = $0                             PMT   =    $0
         PV     = ($48,744.8540)                 PV    =    ($42,241.0807)

        $48,744.8540 + $42,241.0807 = $90,985.9347
    Option E:

         FV     =    $75,000                 n         = 15
         i      =    9                       i         = 9
         n      =    5                       FV        = $175,000
         PMT    =    $0                      PMT       = $0
         PV     =    ($48,744.8540)          PV        = ($48,044.1572)

        $48,744.8540 + $48,044.1572 = $96,789.0112
    To receive $1,500 at the end of each month for 10 years compounded monthly (Option C)
    would be the best investment opportunity for Cody (highest present value).
 9. Patricia and Scott Johnson are ready to retire. They want to receive the equivalent
    of $30,000 in today’s dollars at the beginning of each year for the next 20 years.
    They assume inflation will average 4% over the long run, and they can earn an
    8% compound annual after-tax return on investments. What lump sum do Patricia
    and Scott need to invest today to attain their goal?
    Time Value of Money—Present Value on an Annuity Due Adjusted for Inflation
    Compounded Annually

         PMTAD =         $30,000
         i       =       3.8462 [(1.08 ÷ 1.04) − 1] × 100
         n       =       20
         FV      =       $0
         PV      =       ($429,217.75)

10. Margaret wants to retire in 9 years. She needs an additional $200,000 in today’s
    dollars in 10 years to have sufficient funds to finance this objective. She assumes
    inflation will average 5% over the long run, and she can earn a 4% compound
156   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                               annual after-tax return on investments. What serial payment should Margaret
                               invest at the end of the first year to attain her objective?
                               Time Value of Money—Serial Payments Adjusted for Inflation

                                     FV         =    $200,000
                                     n          =    10
                                     i          =    −0.9524 [(1.04 ÷ 1.05) − 1] × 100
                                     PV         =    0.0000
                                     PMT        =    ($20,872.1783)

                               First-year payment = $20,872.1783 × 1.05 = $21,915.7872 (rounded to $21,915.79)

                                                     Beginning
                                         Year         Balance             Earnings         Deposits   Ending Balance
                                          1                   0.00             0.00    $21,915.79      $21,915.79
                                          2          $21,915.79            $876.63     $23,011.58      $45,804.00
                                          3          $45,804.00           $1,832.16    $24,162.16      $71,798.31
                                          4          $71,798.31           $2,871.93    $25,370.26     $100,040.51
                                          5         $100,040.51           $4,001.62    $26,638.78     $130,680.90
                                          6         $130,680.90           $5,227.24    $27,970.72     $163,878.85
                                          7         $163,878.85           $6,555.15    $29,369.25     $199,803.26
                                          8         $199,803.26           $7,992.13    $30,837.71     $238,633.10
                                          9         $238,633.10           $9,545.32    $32,379.60     $280,558.03
                                         10         $280,558.03          $11,222.32    $33,998.58     $325,778.93

                               Verification

                                     FV         =   $325,778.93
                                     n          =   10
                                     i          =   5
                                     PV         =   $200,000.0029

                         11. Kristi wants to buy a house in 10 years. She estimates she will need $200,000 at
                             that time. She currently has a zero-coupon bond with a market value of $4,600
                             that she will use as part of the required amount. The zero-coupon bond has a
                             face value of $10,000 and will mature in 10 years. The bond has a semiannual
                             effective interest rate of 4.323%. In addition to the bond, she wants to save a
                             monthly amount to reach her goal. What is Kristi’s required monthly payment
                             made at the beginning of each month to accumulate the $200,000, including the
                             zero-coupon bond, at an assumed interest rate of 11%?
                               Time Value of Money—Capital Budgeting with Annuity Due and Beginning Balance

                                                          FV         =     $190,000 ($200,000 − $10,000)
                                                          n          =     120 (10 × 12)
                                                          i          =     0.9167 (11 ÷ 12)
                                                          PV         =     $0.000
                                                          PMTAD      =     $867.6303
180    Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition




      DISCUSSION QUESTIONS AND SOLUTIONS

                            1. What are the issues and goals of education funding?
                                The issues deal with how much education the parents intend to pay for, what schools will
                                the child attend, and how the parents are going to fund the cost of education. A primary
                                financial goal of most parents is to provide an education for their children. Goals are vital
                                for education funding because families are in a better position to fund college expenses over
                                a long time period (the benefit of the time horizon) because, normally, their income will rise
                                in future years.
                            2. What education funding information should students and parents collect?
                                During the goal-setting process, students and parents should gather information that will
                                allow them to forecast tuition and related expenses. This forecasting can be accomplished
                                by first determining current tuition and related expenses for area schools and schools the
                                parents believe would be appropriate for the child. These expenses should be adjusted for
                                inflation until the child enters school. Also, a formula can be used to determine how much
                                money must be invested to meet the amount of savings necessary for college (i.e., the
                                Expected Family Contribution). Other expenses that should be considered are tuition-relat-
                                ed expenses, books and school supplies, lodging, meals, transportation, entertainment and
                                leisure, tutoring (if necessary), extracurricular activities, clothing and other attire, and other
                                considerations particular to the student or family.
                            3. How is financial need determined?
                                When consulting a federal financial aid administrator, the financial aid administrator will
                                calculate a student’s financial need by taking the cost of attendance at the particular school
                                and subtracting the student’s Expected Family Contribution (EFC), determined using factors
                                consisting of taxable and nontaxable income, assets, and benefits such as unemployment and
                                Social Security. The remaining figure equals the student’s financial need. The formula is as
                                follows: Tuition/cost of attendance ($) – EFC ($) = financial need ($).
                            4. What is a Federal Pell Grant?
                                A Federal Pell Grant is not a loan. It is a grant from the federal government that does not
                                require repayment. The EFC calculation, which is based on one’s financial need, is used
                                to determine a student’s eligibility for a Pell Grant and how much is awarded to a student.
                                Pell Grants are awarded to undergraduate students who have not earned bachelor’s or
                                professional degrees.
                            5. What are Direct and FFEL Stafford Loans?
                                There are two types of Stafford Loans: Direct Stafford Loans (Direct Loans) and Federal
                                Family Education Stafford Loans (FFEL Loans). The difference between Direct and FFEL
                                Stafford Loans are the sources of the loan funds and available repayment plans. Funding
                                for Direct Loans are provided directly to the borrower by the United States government,
                                whereas FFEL funds are lent to the student through a lender (such as a bank) that partici-
                                pates in the FFEL program.
                            6. What is the difference between a subsidized student loan and an unsubsidized
                               student loan?
                                A subsidized loan means that there is no interest charged on the loan until repayment of the
                                loan begins. An unsubsidized loan is one in which the borrower is charged interest on the
                                principal from the moment of disbursement until the loan is repaid.
                                                              Chapter 7 | Education Funding    181


 7. What are PLUS Loans?
    Parent Loans for Undergraduate Students (PLUS) are loans that are available through the
    Direct Loan and FFEL programs. PLUS Loans allow parents with good credit histories to
    borrow funds for a child’s educational expenses.
 8. What is a Consolidation Loan?
    A Consolidation Loan provides borrowers with a vehicle to consolidate various types of
    federal student loans with separate repayment schedules into one loan. The Consolidation
    Loan Program benefits student and parent borrowers by extending the term of repayment,
    requiring only one payment per month, and in some cases providing a lower interest rate
    than on one or more of the loans.
 9. What campus-based student financial aid is available?
    Three campus-based programs are administered directly by the financial aid office at partici-
    pating schools: the Federal Supplemental Education Opportunity Grant (FSEOG) Program,
    the Federal Work-Study Program, and the Federal Perkins Loan Program. Each program
    extends aid based on the student’s financial need and the availability of funds at the school.
10. What are the tax advantages and issues with respect to educational expenses?
    Various vehicles are available that allow the family or taxpayer who bears the brunt of edu-
    cation expenses to realize tax savings and benefits, including (1) QTPs, (2) Coverdell ESAs,
    (3) Roth IRAs, (4) the American Opportunity Tax Credit, (5) the lifetime learning credit,
    (6) Series EE Bonds, (7) the Uniform Gift to Minors Act, (8) interest on educational loans,
    and (9) equity lines of credit.
11. What are the benefits of Qualified Tuition Plans and how are they taxed?
    The benefits of QTPs include (1) tax-deferred growth; (2) distributions are excludable from
    gross income; (3) the contributor can remove assets from the taxable estate; (4) QTPs gener-
    ally charge low commissions and have low management fees; (5) many states provide state tax
    deductions or tax exemptions for some contributions to QTPs; and (6) the
    contributor/owner has full control of the asset and can change the beneficiary.
12. What are Prepaid Tuition Plans, and how do they work?
    Prepaid Tuition Plans are plans in which prepayment of tuition is allowed at current prices for
    enrollment in the future. The parent can lock in future tuition at current rates. Risks include
    attendance elsewhere, the child’s failure to meet academic or and admission requirements, and
    a scholarship or an undesirable curriculum in the child’s particular area of interest.
13. How do contributions to QTPs affect gift taxes?
    QTPs permit the owner/contributor to shift his taxable estate to the beneficiary without
    taxation through the annual $13,000 gift tax exclusion. A five-year averaging election for
    purposes of the gift tax annual exclusion may be applied to the transfer. If one’s contribu-
    tions exceed $13,000, the contributor is permitted to spread out one contribution over a
    five-year period. Example: John (father/contributor) contributes $35,000 to a QTP account
    for Matthew (beneficiary/child) in one year. John may spread this contribution over five
    years (i.e., $7,000 per year) and avoid gift tax by using the annual exclusion.
14. What is a Coverdell Education Savings Account?
    Coverdell ESAs are designed to offer tax benefits to those individuals who wish to save
    money for a child’s or grandchild’s higher education expenses. A Coverdell ESA is an
    investment account established with cash where contributions are made for the benefit of
    children under age 18. The contributions are allowed to grow tax free within the account.
    A Coverdell ESA can be established for any child under age 18 by anyone, as long as the
182   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                               contributor who establishes the account does not have $220,000 or more of modified family
                               annual gross income. Contributions are limited to $2,000 per designated beneficiary per year.
                         15. How can a Roth IRA be used for education funding?
                               Although a distribution may not be a qualified distribution if it exceeds actual contributions
                               to the Roth IRA, the distribution will still not be subject to the 10% penalty if the proceeds
                               are used for qualified higher education costs.
                         16. What is the maximum credit permitted with the American Opportunity Tax
                             Credit?
                               The American Opportunity Tax Credit’s maximum credit allowed in a given year is $2,500
                               per student.
                         17. What are the eligibility requirements to use a lifetime learning credit?
                               The lifetime learning credit provides annual reimbursement for college tuition per family
                               in the amount of $2,000 per year. The taxpayer must spend $10,000 annually on qualified
                               higher educational expenses in order to qualify for the full credit. This credit is based on
                               20% of the qualified expenses. For example, to obtain the full $2,000 credit, there must be
                               a qualified higher education expense of at least $10,000. Half-time enrollment or more is
                               required. If the courses taken are geared toward the acquisition or improvement of job skills,
                               the student may be enrolled less than half time.
                         18. What are Series EE bonds?
                               Series EE United States Savings Bonds (EE bonds) are useful tools for college tuition. Face
                               values of EE bonds start as low as $50 and max out at $5,000. They are purchased at one-
                               half of their face value. There is no federal income tax on the interest as it accrues.
                         19. What is the Uniform Gift to Minors Act?
                               The Uniform Gift to Minors Act (UGMA) allows parents the option to put assets in a cus-
                               todial account for a child. If the child is under 18 years of age, some income earned by the
                               assets may be taxed at the parents’ income tax rate (to the extent the child has unearned
                               income in excess of $1,900 for 2010). If the child is 18 years or older, the income earned by
                               the assets is taxed at the tax rate for the child. In 2010, the kiddie tax also applies to full-
                               time students up to age 24.
                         20. What is the Employer’s Educational Assistance Program?
                               Under the Employer’s Educational Assistance Program, an employer can pay for an employee’s
                               undergraduate or graduate tuition, enrollment fees, books, supplies, and equipment while these
                               employer benefits are excluded from the employee’s income up to $5,250.
                                                                       Chapter 7 | Education Funding     183




EXERCISES AND SOLUTIONS

        1. Compare and contrast grants, scholarships, and fellowships.
           Grants are awarded based on financial need. They do not have to be repaid. Similarly, schol-
           arships are funds used to pay for higher education that do not have to be repaid. However,
           scholarships may be awarded based on any number of criteria, such as academics, achieve-
           ments, hobbies, talents, group affiliations, or career aspirations. They usually do not provide
           funds for living expenses. Fellowships are generally awarded to graduate students based on
           academic merit. They often provide funds for living expenses as well as tuition and fees.
        2. Compare and contrast Direct and FFEL Stafford loans.
           The terms and conditions of a Direct Stafford or a FFEL Stafford are similar. The major
           differences between the two are the source of the loan funds, some aspects of the applica-
           tion process, and the available repayment plans. Under the Direct Loan Program, the funds
           are lent directly by the US government. Under the FFEL Program, the funds are lent by a
           bank, credit union, or other lender that participates in the FFEL Program. Direct and FFEL
           Stafford Loans are either subsidized or unsubsidized. An individual can receive a subsidized
           loan and an unsubsidized loan for the same enrollment period. A subsidized loan is awarded
           on the basis of financial need. No interest will be charged before repayment begins or during
           authorized periods of deferment. The federal government subsidizes the interest during these
           periods. An unsubsidized loan is not awarded on the basis of need. Interest is charged from
           the time the loan is disbursed until it is paid in full. If the interest is allowed to accumulate,
           it will be capitalized, that is, the interest will be added to the principal amount of the loan
           and additional interest will be based on the higher amount.
        3. Shawna, age 18, recently graduated from high school with a 3.6 GPA. Shawna
           currently lives at home and works part time as an office assistant. She has been
           accepted to Texas State University. Her parents cannot afford to assist her with
           expenses. She wants to obtain a college education but is having trouble affording
           tuition and other college expenses. What financial aid programs would you rec-
           ommend to Shawna, and why?
           First, Shawna should complete a FAFSA to apply for financial aid and a separate application
           for a FFEL Stafford Loan. Financial aid programs recommended for Shawna include:
           ■ Federal Pell Grants—outright gifts based on need. Shawna may be a good candidate
             because her parents cannot afford to assist her.
           ■ An FSEOG—an outright gift awarded to undergraduate students with low EFCs; gives
             priority to students who receive Federal Pell Grants.
           ■ Stafford Loans—although these need to be repaid, Shawna can apply for subsidized loans
             during school.
           ■ Federal Work-Study programs—Shawna has demonstrated that she can work as an office
             assistant, so she likely can handle financial aid (at least minimum wage or higher) in the
             form of federal work-study.
           ■ Federal Perkins Loan—a loan provided to undergraduate and graduate students with
             exceptional financial need (i.e., very low EFCs), with a low 5% interest loan.
           ■ Scholarships—Shawna should undergo a massive scholarship campaign because she has
             demonstrated financial need (parents cannot afford to assist her), good grades (a common
             criterion for scholarships; she had a very respectable 3.6 GPA in high school) and a good
             work ethic (works part time as office assistant). Each school has its own method of pro-
             viding aid through scholarships, as well as discounts, loans, and campus jobs.
184   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                           4. Karen, age 20, is in her second year at the University of California. She will not
                              be able to hold down a part-time job and complete her bachelor’s degree program
                              in four years. She will receive approximately $30,000 from a trust fund left to
                              her by her grandmother on her 22nd birthday. What federal aid programs are
                              available to Karen? Would you recommend that Karen borrow against the trust
                              fund in order to support herself during the next two years? Why or why not?
                               The federal aid programs available to Karen include Federal Pell Grants, Stafford Loans,
                               PLUS Loans, Federal Supplemental Educational Opportunity Grant (FSEOG), and Federal
                               Perkins Loans. Under these circumstances, the best route for Karen would be to obtain a
                               Stafford Loan that is subsidized. Karen would not need to repay the loan until at least six
                               months after graduation, and if it is subsidized, she could repay the loan within the 2½-year
                               period from her trust fund money without paying any interest on the loan. This would be
                               better than borrowing against the trust fund.
                           5. Gordon and Rhonda want to start saving now for their two-year old daughter’s
                              college education. Tuition and fees at a four-year public university are currently
                              $3,500 per year, and tuition is expected to increase approximately 7% each year.
                              How much should Gordon and Rhonda expect to pay for college when their
                              daughter turns 18?
                               Estimated costs (future value or actual cost) of tuition and fees 16 years from now:

                                     Freshman year:              $10,333 [PV = $3,500; N = 16; I/YR = 7; solve for FV]
                                     Sophomore year:             $11,056 [PV = $3,500; N = 17; I/YR = 7; solve for FV]
                                     Junior year:                $11,830 [PV = $3,500; N = 18; I/YR = 7; solve for FV]
                                     Senior year:                $12,658 [PV = $3,500; N = 19; I/YR = 7; solve for FV]
                                     Total:                      $45,877


                           6. Christian and Emily have 2 children, Bethany, age 5, and Taylor, age 7.
                              Christian’s parents would like to pay for Bethany’s and Taylor’s college educa-
                              tion. They are considering gifting the money to Bethany and Taylor by setting up
                              savings accounts for them. Would you recommend this approach? Why or why
                              not? To whom should the grandparents pass the money, and why?
                               The best approach under these circumstances probably would be a QTP savings account
                               because the grandparents would own and maintain control of the account. Also, because
                               the grandparents own the account, the value of the account will not be considered assets of
                               Christian and Emily or Bethany and Taylor should they seek to obtain financial aid through
                               grants or subsidized loans. Coverdell ESAs are also an option because all withdrawals for
                               qualified educational expenses are tax free, but only $2,000 per year can be contributed to
                               the accounts.
                           7. Brandon and Myra are married and have an adjusted gross income of $55,000.
                              They have 2 children, Beth, age 18, and Brett, age 20. Both Beth and Brett are
                              full-time students attending the local university. Are Brandon and Myra eligible
                              to take advantage of any educational tax credits? If so, which ones, and what is
                              the maximum credit they are allowed?
                               Brandon and Myra are eligible for the American Opportunity Tax Credit and lifetime
                               learning credit. The American Opportunity Tax Credit is available for the first $2,000 of
                               qualified expenses paid in the tax year, plus 25% of the next $2,000. The maximum credit
                               allowed in a given year is $2,500 (2010) per student. The lifetime learning credit provides
                               annual reimbursement of $2,000. Brandon and Myra must spend $10,000 annually on quali-
                               fied expenses to qualify for the full lifetime learning credit. Both credits require more than
                                                               Chapter 7 | Education Funding     185


    half-time enrollment; Brandon and Myra’s $55,000 AGI will not affect either credit if they
    file a joint return (married filing jointly AGI must be at least $100,000 for phaseout to begin
    in 2010. Because Beth and Brett are from the same household and incurred qualified expens-
    es in the same year, Brandon and Myra may claim a lifetime learning credit or American
    Opportunity Tax Credit for both children, or a lifetime learning credit for one child and a
    American Opportunity Tax Credit for the other. However, only one credit is allowed per
    child per year. Also note that the maximum lifetime learning credit of $2,000 applies to the
    family, not per student as with the American Opportunity Tax Credit.
 8. Leslie is in her third year of college and has received subsidized Stafford loans
    to help her pay for college. She does not have to borrow any more money before
    she receives her degree. She wants to start paying off her student loans now.
    Given the choices for repaying student loans, what would you recommend to
    Leslie?
    Because Leslie has subsidized loans in which no interest accrues until she finishes school,
    Leslie should make payments to a savings vehicle whereby she could earn interest in that
    account until 6 months after graduation when repayments must begin and interest begins to
    accrue. In this situation, Leslie could take advantage of the interest-free loan and earn inter-
    est on some of the money she will use to repay the loan.
 9. Brad was recently awarded financial aid through his university. Although the aid
    helped, he still needs more financial aid than the school offered. What would you
    recommend to Brad to help him pay for college?
    Brad should discuss this with his college Financial Aid Office representatives. They may
    be able to identify additional sources of aid or recalculate eligibility—particularly if family
    circumstances have changed since the package was awarded. If Brad still needs additional
    funds, he should look into loan programs that are not based on need, including unsubsidized
    Stafford loans, parent loans, and private loans.
10. Tyra plans to attend the local university next year. Her parents make too much
    money to qualify for federal aid programs, but Tyra still needs assistance. What
    financial aid, if any, is available for Tyra?
    This is not unusual, especially when parents are applying for a loan on the behalf of a stu-
    dent. Tyra should apply for federal aid and school-based programs anyway—she may be eli-
    gible for more aid than she thinks. If Tyra still needs aid, she should look into loan programs,
    including unsubsidized Stafford loans, parent loans, and private loans that are not based on
    need.
11. Julie’s parents would like to assist her with the cost of college tuition. Tuition
    and fees are estimated at $13,000 per school year. Julie’s parents apply and qual-
    ify for a PLUS loan. How much can they borrow?
    The yearly limit on a PLUS Loan is equal to the cost of attendance minus any other finan-
    cial aid received. For example, Julie’s cost of attendance is $13,000. If Julie receives $10,000
    in other financial aid, her parents could borrow up to, but no more than, $3,000.
12. John and Sue, both age 30, have a child born today. They plan to save the maxi-
    mum amount in their respective IRAs until their child goes to college in 18 years.
    Would you recommend a Roth IRA or a Coverdell ESA? Explain.
    A Roth IRA is recommended because more money can be invested each year into a Roth
    IRA ($5,000 for 2010) versus only $2,000 per year for a Coverdell ESA. In addition, any
    remaining funds can be used for retirement. The value of the Roth IRA would be higher
    by the time the child turns 18. The withdrawals from Coverdell ESAs used to pay higher
    education expenses are not subject to taxation or penalty. The withdrawals from Roth IRAs
    are subject to taxation for amounts above contributions but are not subject to the penalty.
186   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                               Therefore, it would be best to fund both the Coverdell ESA and the Roth IRA to ensure
                               that there are sufficient funds for the child’s education. In addition, the leftover money in
                               the Roth could be used to help fund retirement.
                         13. David intends to open a QTP for his daughter but wants to know if he can direct
                             the specific investments himself. Can David direct where and how much of the
                             contributions are invested? Can David direct how much of the funds are used to
                             purchase stock or bonds? Explain.
                               No, David cannot direct the specific investments himself, though he can select a particular
                               mutual fund within a plan. David cannot direct when and how much of the contributions
                               are invested, although David as owner/contributor of the QTP has the ability to put how-
                               ever much of his funds he desires into the QTP. The distinction is that once he invests his
                               money into the plan, the manager of the account directs the investments. Finally, the plan
                               manager (not the owner/contributor) directs how much of the funds are used to purchase
                               stocks or bonds, normally depending on the age of the student/beneficiary.
                         14. In the prior exercise, David was interested in placing a percentage of the QTP
                             funds into stocks and a percentage into bonds. What is this principle called?
                             Also, provide an example as to how it is used.
                               This principle is called age-banding. For example, for a 10-year-old student, 80% of fund are
                               placed in stocks, 20% in bonds, and 0% in money market/cash. Age-banding, within various
                               ranges, is mandatory in all QTPs.
                         15. Robby plans to attend college but cannot afford tuition. He decides to apply
                             for federal financial aid. Generally, how will Robby’s financial aid eligibility be
                             calculated?
                               The Expected Family Contribution (EFC) for a child’s education indicates how much of a
                               student’s family’s resources ought to be available to assist in paying for the student’s educa-
                               tion. Some of the factors used in this calculation include taxable and nontaxable income,
                               assets, retirement funds, benefits such as unemployment and Social Security, the number
                               of children in private school or college, the size of the family, the number of years until
                               the parents’ retirement, and large financial burdens such as medical bills. The financial aid
                               administrator will calculate the student’s financial need by taking the cost of attendance
                               at the school and subtracting the student’s EFC. The remaining figure equals the student’s
                               financial need, as shown:
                                                 Tuition/cost of attendance ($) – EFC ($) = financial need ($).
                               Financial need thus depends on the cost of attendance. Financial aid administrators in their
                               discretion can adjust the cost of attendance or adjust data in calculating a student’s EFC if
                               circumstances require.
                         16. Bob established a QTP Savings Plan for his son Ricky at age 5. When Ricky
                             turned 18, Ricky decided not to attend college and began working as a bartender
                             in the Bahamas. Can Ricky withdraw funds from the QTP account, which has a
                             value of $100,000? What can Bob do (if anything) with the account?
                               Ricky cannot withdraw the funds from the account because Bob is the owner of the account
                               and thus controls the withdrawal and payment of expenses. Bob can, however, change the
                               beneficiary of the account to a different eligible person or take the money, subject to penalty
                               and taxation.
                                                              Chapter 7 | Education Funding   187


17. Claire established a QTP Savings Plan for Matt, her son. While Matt was
    attending college, he asked Claire for money to buy a ski boat. Claire agreed,
    withdrew $10,000 from the QTP account, and purchased the boat for Matt in
    Matt’s name. Will this $10,000 withdrawal and payment be taxed, and if so,
    whose tax rate will be used? Would it be important to know what portion of the
    $10,000 represents contributions and what portion represents earnings? Explain.
    The owner/contributor, Claire, will be taxed at her own tax rate (not Matt’s rate) on the
    earnings portion of the $10,000 withdrawal. It is, therefore, important to know what portion
    of the $10,000 represents contributions and what portion represents earnings. The custodian
    may also charge a fee for withdrawal.
18. Let’s take the prior exercise (exercise 17) one step further. Would there be any
    penalty assessed on the $10,000 withdrawal? Would it be important to know
    what portion of the $10,000 is contributed and what portion is earnings?
    Under these facts, Claire would be assessed with a 10% penalty on the earnings only. It is,
    therefore, important to know what portion of the $10,000 represents contributions and what
    portion represents earnings.
19. What if in the prior exercise (exercise 17), Matt had received a full scholarship
    for his remaining years in college the semester before Claire gave him $10,000
    for the boat?
    As discussed earlier, if a portion or all of the withdrawal is spent on anything other than
    qualified higher education expenses, Claire as owner/contributor will be taxed at her own
    tax rate on the earnings portion of the withdrawal. A penalty is not imposed, however, if
    Matt, the student/beneficiary, receives a scholarship.
188    Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition




      PROBLEMS AND SOLUTIONS

                            1. Rena and Hunter Alesio have two children, ages 5 and 7. The Alesios want to
                               start saving for their children’s education. Each child will spend 6 years at col-
                               lege and will begin at age 18. College currently costs $20,000 per year and is
                               expected to increase at 6% per year. Assuming the Alesios can earn an annual
                               compound return of 12% and inflation is 4%, how much must the Alesios
                               deposit at the end of each year to pay for their children’s educational require-
                               ments until the younger child is out of school? Assume that educational expenses
                               are withdrawn at the beginning of each year and that the last deposit will be
                               made at the beginning of the last year of the younger child.
                                Answer: $14,989

                                Age of older child        7                         18      19     20   21   22   23   24   25



                                Older child cash flows                               20k 20k 20k 20k 20k 20k

                                Younger child cash flows                                            20k 20k 20k 20k 20k 20k

                                Total cash flows                                     20k 20k 40k 40k 40k 40k 20k 20k

                                Method 1—Traditional
                                Step 1: Determine PV of tuition costs.
                            PV younger child @ 20                                       PV older child @ 18
                            FV = $0                                                     FV = $0
                            n=6                                                         n=6
                            i = 5.66 {[(1.12 ÷ 1.06) – 1] × 100}                        i = 5.66
                            PMT = $20,000                                               PMT = $20,000
                            PVAD = $105,032                                             PVAD = $105,032

                            PV younger child @ 7                                        PV older child @ 7
                            FV = $105,032                                               FV = $105,032
                            n = 13 (20 – 7)                                             n = 11 (18 − 7)
                            i = 5.66                                                    i = 5.66
                            PMT = $0                                                    PMT = $0
                            PVOA = $51,343                                              PVOA = $57,320
                            Note: The inflation rate for this problem reflects the educational inflation rate of 6%.

                                The solution was provided using an inflation-adjusted earnings rate.
                                Total cost in today’s dollars:
                                Younger child = $51,343
                                Older child = 57,320
                                                 $108,663
                                                                          Chapter 7 | Education Funding   189


      Step 2: Determine yearly payment.
PV                = $108,663
n                 = 18 (23 – 5)
i                 = 12
FV                = $0
PMTOA             = $14,989

Method 2—Uneven cash flows

Step 1:                                                              Step 2:
                           Cash flows                                Yearly payment
CF7–17             =       (0)                                       PV              = ($108,663)
CF18–19            =       20k                                       n               = 18 (23 − 5)
CF20–23            =       40k                                       i               = 12
CF24–25            =       20k                                       FV              = 0
i                  =       5.66 [(1.12 ÷ 1.06) 1] × 100              PMTOA           = $14,989
NPV                =       $108,663

2. Chelsea was recently divorced and has two children. The divorce decree requires
   that she pay 1/3 of the college tuition cost for her children. Tuition cost is cur-
   rently $15,000 per year and has been increasing at 7% per year. Her son and
   daughter are 12 and 16, respectively, and will attend college for four years begin-
   ning at age 18. Assume that her after-tax rate of return will be 9% and that gen-
   eral inflation has been 4%. How much should she save each month, beginning
   today for the next 5 years to finance both children’s education?
      Answer: $745.01

      Age of older child             16   17     18   19   20   21   22    23   24   25   26



      Older child cash flows                           15k 15k 15k 15k

      Younger child cash flows                                             15k 15k 15k 15k

      Total cash flows                                 15k 15k 15k 15k 15k 15k 15k 15k


Step 1: Determine PV of tuition costs.
CF0                           = $0
nj                            = 2
CFj                           = $15,000
nj                            = 8
i                             = 1.86916        {[(1.09 ÷ 1.07) – 1] × 100}
NPV                           = $108,476.87
Chelsea’s portion             = $36,158.96 ($108,476.87 ÷ 3)
190   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition



                           Step 2: Determine monthly payment.
                           PV                           = ($36,158.96)
                           i                            = .75 (9% ÷ 12)
                           n                            = 60 (5 × 12)
                           PMTAD                        = $745.01
                                Note: Discrepancies may occur when combining annual compounding with monthly com-
                                pounding within the same problem.
                           3. Ken and Amy Charvet have two children, ages 4 and 6. The Charvets want to
                              start saving for their children’s education. Each child will spend 5 years at col-
                              lege and will begin at age 18. College currently costs $30,000 per year and is
                              expected to increase at 7% per year. Assuming the Charvets can earn an annual
                              compound investment return of 12% and inflation is 4%, how much must
                              the Charvets deposit at the end of each year to pay for their children’s educa-
                              tional requirements until the youngest goes to school? Assume that educational
                              expenses are withdrawn at the beginning of each year and that the last deposit
                              will be made at the beginning of the first year of the youngest child.
                                Answer: $22,886

                                Age of older child        6                   17   18   19       20   21   22       23       24   25



                                Older child cash flows                              30k 30k 30k 30k 30k 30k

                                Younger child cash flows                                      30k 30k 30k 30k 30k 30k

                                Total cash flows                                    30k 30k 60k 60k 60k 60k 30k 30k

                                Method 1—Traditional
                                Step 1: Determine PV of tuition costs.
                           PV older child @ 17                                               PV younger child @ 19
                           FV              = $0                                              FV                 =        $0
                           n               = 5                                               n                  =        5
                           i               = 4.6729                                          i                  =        4.6729
                           PMT             = ($30,000)                                       PMT                =        ($30,000)
                           PVOA17          = $131,067                                        PVOA17             =        $131,067


                           PV Oldest Child @ 6                                               PV Youngest Child @ 6
                           FV17            = $131,067                                        FV                 =        $131,067
                           n               = 11 (17 – 6)                                     n                  =        13 (19 – 6)
                           i               = 4.6729                                          i                  =        4.6729
                           PMT             = $0                                              PMT                =        $0
                           PVOA            = ($79,308)                                       PVOA               =        ($72,385)

                                Total cost in today’s dollars:
                                Older child =   $79,308
                                Younger child = 72,385
                                               $151,693
                                                            Chapter 7 | Education Funding   191



Step 2: Determine yearly payment.
PV           =   ($151,693)
n            =   14 (20 – 6)
i            =   12
FV           =   $0
PMTOA        =   $22,886


Method 2—Uneven cash flows
Step 1:                                                   Step 2:
Cash flows                                                Yearly payment
CF6–17           = 0                                  PV            =   $151,693
CF18–19          = 30,000                             n             =   14 (20 – 6)
CF20–22          = 60,000                             i             =   12
CF23–24          = 30,000                             FV            =   0
i                = 4.6729 [(1.12 ÷ 1.07) 1] × 100     PMT           =   ($22,886)
NPV              = ($151,693)
4. Barry and Virginia have a 5-year-old son, Daniel. They have plans for Daniel to
   attend a 4-year private university at age 18. Currently, tuition at the local pri-
   vate university is $15,000 per year and is expected to increase at 7% per year.
   Assuming Barry and Virginia can earn an annual compound return of 10% and
   inflation is 4% how much do Barry and Virginia need to start saving per year,
   starting today, to be able to pay for Daniel’s college education? Assume their last
   payment is made at the beginning of Daniel’s first year in college.
     Answer: $4,960.95 per year
     Method 1—Traditional
     Step 1: Determine PV of tuition costs.

PV @ 17
FV            = $0
n             = 4
i             = {[(1.10 ÷ .07) – 1] × 100} = 2.8037
PMT           = ($15,000)
PVOA17        = $56,019.15
PV @ 5
FV17          = $56,019.15
n             = 12 (17 – 5)
i             = 2.8037
PMT           = $0
PVOA          = ($40,200.51)

     Total cost in today’s dollars: $40,200.51
Step 2: Determine yearly payment.
PV           = ($40,200.51)
n            = 14 (Payments start today and continue until Daniel reaches 18)
i            = 10
FV           = $0
PMTAD        = $4,960.95

Or: Uneven cash flows
Step 1:                                                    Step 2:
Cash flows                                                 Yearly payment
CF5–17         = 0                                         PV          =    $40,200.33
CF18–21        = $15,000                                   n           =    14
i              = [(1.10 ÷ 1.07) 1] × 100 = 2.8037          i           =    10
NPV            = ($40,200.33)                              FV          =    0
                                                           PMTAD       =    ($4,960.95)
                                         Chapter 8 | An Introduction to Insurance and Risk Management   209




DISCUSSION QUESTIONS AND SOLUTIONS

        1. What is risk?
           Risk is the chance and/or possibility of loss.
        2. What are the different types of risk, and how does each impact the personal
           financial planning process?
           The different types of risk discussed in the chapter are as follows:
           ■ Dynamic risk—results from changes in society or the economy
           ■ Static risk—involves losses that would occur even though there were no changes in
             society or the economy
           ■ Pure risk—one in which the results are either loss or no loss
           ■ Speculative risk—one where profit, loss, or no loss may occur
           ■ Subjective risk—a particular person’s perception of risk
           ■ Objective risk—a more concrete concept that does not depend on a particular person’s
             perception of risk; it is that risk that exists in the real world, usually quantitatively
             measurable
           ■ Particular risk—personal and involves a possible loss for individuals or small groups or
             individuals, rather than a large segment of the population
           ■ Fundamental risk—impersonal and involves a possible loss for a large group
           ■ Financial risk—involves monetary losses
           ■ Nonfinancial risk— involves a nonmonetary loss
           During the financial planning process, the planner must help the client determine which
           risks to insure or not.
        3. What is the difference between subjective and objective risk?
           Subjective risk is a particular person’s perception of risk and varies greatly from individual
           to individual. Objective risk is a more concrete concept and does not depend on a particular
           person’s perception of risk and exists in the real world, usually quantitatively measurable.
        4. Name the common responses to risk. For which of the response(s) is insurance
           an appropriate risk management tool?
           Common responses to risk include risk avoidance, risk reduction, risk retention/assumption,
           and risk transference. Insurance transfers the risk of loss to the insurer who is, a financial
           intermediary that specializes in assuming risk. The insured pays a premium to agree that if
           certain events (losses) occur, money will be provided to the insured to pay for the conse-
           quences of those losses. In exchange, the insurer provides the insured with a legally binding
           contract that spells out how those losses will be valued and what duties are owed by each
           party to the contract.
        5. How does a peril differ from a hazard, and how does each relate to the need for
           insurance?
           A peril is the proximate, or actual, cause of a loss. Insurance policies are written on the basis
           of a loss due to a peril. A hazard is a condition that creates or increases the likelihood of a
           loss occurring.
210   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                          6. What is adverse selection, and how does it affect the insurance contract?
                               Adverse selection is the tendency of higher-than-average risks (i.e., people who need insur-
                               ance the most) to purchase or renew insurance policies. Insurance policy participants need
                               to be selected so that adverse selection does not occur. If adverse selection occurs, the insur-
                               ance company will have much larger losses than anticipated and are, therefore, not manag-
                               ing risk appropriately.
                          7. What are the requisites for an insurable risk, and what distinguishes insurance
                             from gambling?
                               There are several conditions that must exist before a pure risk is considered to be an
                               insurable one.
                               ■ There must be a large number of homogeneous (similar) exposure units.
                               ■ Insured losses must be accidental from the insured’s standpoint.
                               ■ Insured losses must be measurable and determinable.
                               ■ Loss must not pose a catastrophic risk for the insurer.
                               ■ Premiums must be affordable.
                               Insurance allows the insured to transfer a risk to the insurer, whereas gambling creates a risk
                               where none previously existed.
                          8. What are the elements of a valid contract? What distinguishing features do
                             insurance contracts possess?
                               The elements of a valid contract are:
                               ■ offer and acceptance;
                               ■ legal competency of all parties;
                               ■ legal consideration; and
                               ■ lawful purpose.
                               The distinguishing features of insurance contracts are:
                               ■ the principle of indemnity;
                               ■ the principle of insurable interest; and
                               ■ the principle of utmost good faith.
                          9. What is the reason for and the effects of various contractual features in insur-
                             ance policies?
                               The reason there are contractual features in an insurance policy is that they clarify the con-
                               tract terms, therefore controlling, among others, the terms of coverage, benefits, responsibili-
                               ties, and exclusions.
                         10. What is the principle of indemnity?
                               The principle of indemnity states that a person is entitled to compensation only to the
                               extent that a financial loss has been suffered.
                         11. What is the principle of insurable interest?
                               To have an insurable interest, an insured must be subject to emotional or financial hardship
                               resulting from damage, loss, or destruction of property. The principle of insurable interest as
                               a legal principle is consistent with the principle of indemnity. The principle requires that
                               for property insurance, the insured must have an insurable interest both when the contract
                               is issued and at the time of loss. For life insurance, the insurable interest must be at the issu-
                               ance of the contract.
                                 Chapter 8 | An Introduction to Insurance and Risk Management   211


12. What is a contract of adhesion?
    Adhesion is a characteristic of insurance that means that insurance is a take-it-or-leave-it
    contract. The insured must accept (or adhere to) the contract as written, without any bar-
    gaining over the terms and conditions.
13. Distinguish between an agent and a broker.
    An agent is a legal representative of the insurer and has authority to enter into agreements
    on the insurer’s behalf. Agents market and sell policies for insurance companies. In contrast,
    brokers are legal representatives of the insured and can offer products from many insurers.
    Many are also licensed to sell insurance products, which facilitates the issuance of policies.
14. Differentiate between a general agent, an independent agent, and a surplus-line
    agent.
    A general agent is an independent businessperson who represents only one insurer in a
    designated territory and is responsible for hiring, training, and paying other agents to work
    under the supervision of the agency. The general agent is compensated by commissions
    received from the insurance company for sales produced by the agency, and, in addition, the
    insurer may provide some financing for office expenses.
    Independent agents usually represent multiple unrelated insurers through the US agency
    system.
    Sometimes the policy requested by a consumer is not available from an admitted (in-state)
    insurer. In this situation, surplus line agents will be employed. These agents have the author-
    ity to place business with non-admitted (out-of-state) insurers when necessary insurance is
    not available within the state.
15. Describe the various of type of agent authority.
    Express authority involves powers that are explicitly given or denied to the agent by the
    insurer. Usually, these are stated in the agency agreement between the agent and the insurer.
    Implied authority gives the agent the power to perform any incidental act required in fulfill-
    ing the obligations of the agency agreement.
    Apparent authority states that the insurer is bound by acts of the agent if a third party is
    reasonably led to believe that the agent’s actions are within his authority as a representative
    of the insurer. The insurer may be liable for misstatements by the agent even if it is unaware
    of such acts. Apparent authority is based on the principle of estoppel, which asserts that an
    insurer may be liable for unauthorized actions of an agent if the company was aware of the
    action but did nothing to prevent it.
16. What are the insurable loss exposures faced by the typical individual consumer?
    ■ Dying too soon
    ■ Living too long
    ■ Accidents and illnesses
    ■ Damage to property
    ■ Legal liability for injuries inflicted upon others
212   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                         17. What are the various insurance company rating agencies? Describe each.
                               A.M. Best, Inc. has been providing ratings for insurance companies since 1899. Specializing
                               in insurance companies, it is the largest and longest-established company devoted to issuing
                               in-depth reports and financial-strength ratings.
                               Fitch Investors Service, Inc., provides credit opinions for over 800 insurance companies.
                               Moody’s Investors Service is a source for credit ratings, research, and the risk analysis of
                               thousands of companies, including insurers. Generally, Moody’s analyzes the financial condi-
                               tion of a company at its request, therefore using internal and external information. It also
                               rates some companies with only available public information.
                               Standard & Poor’s Corporation provides two types of ratings. Claims-paying ability rat-
                               ings are issued by request of a company. There is a cost to the requesting company for this
                               service. Qualified solvency ratings are issued using public information only and are free of
                               charge.
                         18. What are the steps in the risk management process?
                               1. Determine the objectives of the risk management program.
                               2. Identify the risk to which the company is exposed.
                               3. Evaluate the identified risks as to the probability of outcome and potential loss.
                               4. Determine alternatives for managing risks and select the most appropriate alternative for
                                  each risk.
                               5. Implement a risk-management plan based on the selected alternatives.
                               6. Periodically evaluate and review the risk management program.
                         19. How do frequency of loss and severity of loss affect risk management?
                               Individuals can determine whether to retain, reduce, avoid, or insure risks on the basis of the
                               frequency and severity of loss.
                                        Chapter 8 | An Introduction to Insurance and Risk Management   213




EXERCISES and SolutionS
        1. Briefly explain the difference between pure and speculative risk. Give an example.
           A pure risk is one in which the results are either loss or no loss. An example of a pure risk
           is death. A speculative risk is one where profit, loss, or no loss may occur. A new business
           start-up is an example of a speculative risk.
        2. Name three perils that could cause a loss around a home or apartment. What are
           the hazards that may increase the probability of these perils?
           Common perils that could affect a home include fire, windstorm, tornado, earthquake, and
           burglary. The student may list other examples of perils. The student should discuss how a
           moral hazard, morale hazard, and physical hazard would affect the perils. Examples of pos-
           sible answers are shown below:
           ■ Fire
              — Moral: setting fire just to receive the proceeds
              — Morale: leaving candles burning unattended because insurance exists
              — Physical: flammable items that increase the likelihood of fire
           ■ Windstorm
              — Moral: leaving windows open to ruin carpets
              — Morale: not protecting windows during a storm
              — Physical: living in a windstorm area
        3. Explain the difference between moral hazard and morale hazard. Give two exam-
           ples of each.
           A moral hazard is a character flaw or level of dishonesty that causes or increases the chance
           for loss. Morale hazard is the indifference to loss based on the existence of insurance. An
           example of moral hazard is arson or lying about a theft. An example of a morale hazard is
           leaving the door to a home unlocked or leaving a hot iron unattended.
        4. Differentiate between gambling and insurance.
           Insurance allows an insured to transfer a risk to the insurer, whereas gambling creates a risk
           where none previously existed.
        5. How would you reduce or manage the risk of adverse selection in a group dental
           insurance program?
           To reduce adverse selection, the underwriter would ask the group questions regarding their
           dental history. Because it is a group policy, the insurer would not be able to exclude certain
           individuals, but rather would use the information to establish the premiums at a level that
           would compensate for the adverse selection risk.
        6. John has an insurance policy for $150,000 on a building located at 175 Pine
           Street. The policy expires on December 31, 2010. John sold the property to Bill
           on October 31, 2010, for $150,000. That very night, the building burned to
           the ground. Can John collect on the policy? If so, how much? If not, what legal
           characteristics would prevent him from collecting? Will John get any money from
           the insurer?
           John will not be able to collect on the policy because he does not have an insurable interest
           at the time of loss. In addition, John may get a refund of any unused premium payment.
214   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                          7. Which of the following people have an insurable interest in Mike’s life?
                                1. Angel, Mike’s 25-year-old daughter
                                2. James, Mike’s 30-year-old son
                                3. Cassie, Mike’s ex-wife and Angel’s mother
                                4. John, Mike’s employer
                                5. Donna, Mike’s daughter-in-law
                                6. Scott, Mike’s business partner
                                7. Rita, Mike’s fiancée
                                    1. Yes
                                    2. Yes
                                    3. Yes
                                    4. Yes
                                    5. Yes
                                    6. Yes
                                    7. Possibly

                               Numbers 1 through 6 all have emotional and/or financial ties to Mike and thus have an
                               insurable interest in Mike’s life. Rita may also have emotional/financial ties.
                          8. Leon is the risk manager for ABC, Inc. He has evaluated the following risks in
                             terms of frequency and severity and asks your opinion as to which risk manage-
                             ment tool(s) to use:

                                                                                   Probability/Frequency Severity Per Occurrence
                           A   Fire destroys factory                                       .0001              $10,000,000
                           B   Loss of property                                            .1                      $1,000
                           C   On-the-job employee disability                              .01                 $1,500,000
                           D   Loss due to misplaced inventory (computer)                  .1                      $2,000
                           E   Loss due to failure to reduce energy bill                   .02                       $400
                               (lights off, air conditioner off on weekends)
                           F   Air conditioning unit failure (compressor)                  .01                     $2,000

                               (The student may give various answers for each scenario; the validity of the answer
                               should be based on the explanation. Below are appropriate answers.)
                               A. Insurance/transference
                               B. Retention/reduction
                               C. Avoidance/insurance
                               D. Retention/reduction
                               E. Retention/reduction
                               F. Retention/reduction
                                                Chapter 9 | Managing Life, Health, and Disability Risks   239




DISCUSSION QUESTIONS AND SOLUTIONS

        1. What are some of the potential losses associated with premature death? How can
           life insurance reduce (or eliminate) the effect of the losses?
           Premature death, catastrophic illness, disability, and the cost of long-term care are reasons
           for life insurance. Financial planners recognize two fundamental needs for the capital gener-
           ated by a life insurance policy: replacing income and preserving assets.
        2. What are the three recognized methods for measuring the needs related to pre-
           mature death?
           The needs approach, the human life value approach, and the capital retention approach.
        3. What is used as the basis for risk measurement under the human value life
           approach to identifying life insurance needs?
           Under the human value life approach, an individual’s income-earning ability is the basis for
           risk measurement.
        4. What component needs make up the financial needs approach to the amount of
           life insurance needed?
           ■ Income during the readjustment period
           ■ Final expense fund
           ■ Life income to widow(er)
           ■ Educational funds for dependents
           ■ Emergency funds
           ■ Retirement funds
        5. How do term, whole, and universal life insurance differ? What are the advan-
           tages and disadvantages of each policy?
           Term insurance is payable only if the insured dies within the designated number of years,
           or term, of the contract. Whole life insurance provides protection for the insured’s entire
           life, whereas term insurance expires after a certain number of years. Term life is pure death
           protection and tends to be quite affordable in the early years of the policy. Perhaps the
           most notable limitation of term insurance is the increase in premiums based on age, making
           term insurance impractical for many older people. Term insurance should never be viewed
           as a form of lifetime protection because it generally may not be renewed after age 65 or 70.
           Unlike term insurance, which exists solely to provide death protection, a whole life policy
           may be purchased as a low-risk investment. Unlike term life, in which premiums increase
           with age, a whole life policy is based on a level premium throughout the payment period.
           Because of the savings feature attached to whole life, many consumers may be attracted to
           the policy. However, the problem of inadequate coverage exists when people can afford only
           a certain amount of whole life when they really need to purchase more to cover the family’s
           needs. Universal life, unlike term and whole life insurance, allows for flexible premium pay-
           ments and flexible death benefit coverage within limits. Also, in many cases, universal life
           may provide a higher cash value than a whole life policy because interest rates credited are
           often higher than those of whole life policy.
        6. Identify and discuss the various types of term life insurance.
           Annual renewable term (ART), level term, term to age 65 or 70, decreasing term, and
           reentry term.
240   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                          7. Identify and discuss the various types of whole life insurance.
                               Ordinary life (straight life), limited-payment, modified life, single premium, current assump-
                               tion (interest sensitive), variable life, and joint life.
                          8. Identify and discuss the death benefit options offered in a universal life
                             insurance policy.
                               Option A (option 1) pays a level death benefit. The net amount at risk (NAR) for a univer-
                               sal life policy is the difference between the cash value and the death benefit. The NAR of
                               an Option A policy decreases as the cash value increases. Option B (option 2) provides an
                               increasing death benefit, which is the net amount at risk (NAR) plus the policy’s cash value.
                               Generally, the NAR of an Option B policy remains level throughout the policy.
                          9. What differentiates variable life insurance from variable universal life insurance?
                               Variable life’s premium amount is fixed and subject to a required minimum, whereas variable
                               universal life’s premium amount is flexible.
                         10. At what threshold is an employee taxed on group term life insurance provided by
                             an employer?
                               If an employer provides group term insurance, the insured may receive up to $50,000 of
                               group term without having to pay income tax on the premiums paid by the employer.
                         11. How do annuities differ from life insurance contracts?
                               Life insurance is awarded for dying, whereas an annuity is awarded for living.
                         12. What are the various types of annuities?
                               Immediate, deferred, flexible-premium, single-premium, fixed, variable, and equity indexed.
                         13. What are the tax implications of life insurance and annuities?
                               Life insurance proceeds are not taxable as income to the recipient. The interest accumulated
                               on a cash value life insurance policy is tax deferred. If the insured dies without surrendering
                               the policy and withdrawing the cash value, the cash value accumulation is usually not sub-
                               ject to tax (see transfer for value exception). When annuitized, each payment from an annu-
                               ity is considered part tax-free return of principal and part taxable income (exclusion ratio).
                         14. What are the various contractual provisions and options that pertain to life and
                             annuity contracts?
                               The various contractual features that may be available in a life insurance contract include a
                               renewability feature, convertibility, grace period, incontestability clause, suicide clause, rein-
                               statement and loan provision, exclusions, nonforfeiture, and dividend options. An annuity
                               contract is designed to provide payments to the annuitant at specified intervals, usually for
                               a fixed period for the annuitant’s life or for the lives of two or more joint annuitants. Types
                               of annuities include immediate or deferred; flexible premium or single premium; and fixed,
                               variable, or equity indexed. Annuity payments vary for straight life annuities, life annuities
                               with period certain, installment refund annuities, and joint and survivor annuities.
                         15. What are the major types of individual health coverage?
                               Hospital expense insurance, surgical expense insurance, and physician’s expense insurance.
                         16. What are the important policy provisions and major contractual features of
                             individual health coverage?
                               The student may choose to discuss any of the topics in the text regarding contractual fea-
                               tures. Examples of appropriate topics would include exclusions to policies (eye care or den-
                               tal), limitations, disability definitions, and integration and termination of benefits.
                                         Chapter 9 | Managing Life, Health, and Disability Risks   241


17. What are the major types of employer-provided group health insurance coverage?
    Basic and major medical, dental and vision, and managed care.
18. What are the important policy provisions and major contractual features of group
    health coverage?
    The student may choose to discuss any of the topics in the text regarding contractual fea-
    tures. Examples of appropriate topics would include exclusions to policies (eye care or den-
    tal), limitations, disability definitions, integration and termination of benefits, and managed
    care issues.
19. What is the purpose of disability income insurance? What are some of the
    various definitions of disability?
    Disability income insurance provides a regular income while the insured is unable to work
    because of illness or injury. The various definitions of disability are “any occupation,” “own
    occupation,” and a combination of the two. A person insured under the any occupation
    clause is considered totally disabled if he cannot perform the duties of any occupation for
    which he is qualified by experience, education, and training. The own occupation definition
    states that the insured must be unable to perform the substantial and major duties of his own
    occupation.
20. What are the major types of disability coverage?
    A person covered by the “any occupation” definition is considered totally disabled if he can-
    not perform the duties of any occupation. The “own occupation” definition is much more
    liberal. Most policies include a combination of the two definitions. Typically, the “own occu-
    pation” will apply only during the early years of the policy. After that, the “any occupation”
    definition applies.
21. What are the important policy provisions and major contractual features of
    disability income insurance?
    The benefit period can provide for short-term (up to two years) or long-term coverage. The
    elimination period is a waiting period before disability payments begin. Benefit payments
    may be made for partial disability. Waiver of premium removes the requirement that the
    policyowner make premium payments after the insured has been disabled for
    90 days, or the elimination period, if shorter. The cost-of-living rider preserves the
    purchasing power of the insured’s disability income benefits. Under the future increase
    option, potential monthly benefits can be increased regardless of any health changes. The
    automatic increase rider raises the total monthly benefit coverage each year for a specific
    number of years, with no increase thereafter. Some policies integrate with Social Security.
    Under residual benefits, the policyowner receives a percentage of the disability benefit based
    on the percentage of income lost due to illness or injury.
22. What is the tax treatment of health and disability insurance coverage?
    Currently, employer-provided medical expense coverages are not taxable as income to the
    employee, and the premiums paid by the employer are tax deductible as a business expense.
    Employer-paid premiums for disability income coverage may not be taxed as current income
    to the employee, but if a disability occurs, the benefits paid out by the plan are taxable
    income to the employee. If the employee pays the entire cost of disability income cover-
    age, the premiums are generally not tax deductible for the employee. The advantage to this,
    however, is that any disability benefits received from the policy are not subject to income
    tax. If the employer and employee share the cost of disability income coverage, disability
    benefits are partially taxable as income to the employee. Only the portion that is attribut-
    able to employer contributions is taxable income to the disabled employee.
242   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                         23. How do indemnity plans and managed care plans differ?
                               The major medical coverages discussed in the chapter are examples of indemnity plans. An
                               indemnity plan agrees to pay a certain percentage of covered medical expenses the insured
                               person incurs, whereas a managed care plan agrees to provide needed medical services.
                               There is no contractual arrangement between the major medical insurer and the doctor (or
                               other service provider). A managed care plan, however, contracts with doctors and hospitals
                               and other health care providers, and it contracts with persons who wish to receive health
                               care services.
                         24. How can group health coverage be continued or transferred when employment
                             terminates?
                               Upon permanent termination of employment with a company, one may still maintain group
                               health insurance benefits for 31 days. This opportunity is extended to the former employee
                               so that he will have adequate time to replace the group insurance with individual insurance.
                               If new employment provides health insurance for the terminated employee, the previous
                               employer’s coverage automatically expires even if the 31-day period has not ended. Other
                               programs include HIPAA and COBRA. HIPAA helps reduce or eliminate the delay caused
                               by preexisting clauses that make continuous health insurance difficult when changing jobs.
                               COBRA requires companies of a certain size to offer continued coverage to employees who
                               terminate, but the employee is responsible for up to 102% of the health insurance premiums.
                                                Chapter 9 | Managing Life, Health, and Disability Risks   243




EXERCISES AND SOLUTIONS

        1. Comment on each of the following statements concerning the methods of provid-
           ing life insurance protection.
           ■ An insurance company can use three approaches to provide life insurance protection:
             term insurance, which is temporary; whole life insurance, which is permanent protection
             that builds up a reserve or savings component; and universal life, which is protection that
             accrues cash value at interest rates higher than the guaranteed interest rate.
           ■ Term insurance is a form of life insurance in which the death proceeds are payable in the
             event of the insured’s death during a specified period and nothing is paid if the insured
             survives past the end of the period.
           ■ The net premium for term insurance is determined by the morbidity rate for the attained
             age of the individual.
           ■ Because death rates rise at an increasing rate as ages increase, the net premium for term
             insurance also rises at an increasing rate.
           ■ Universal life insurance offers the policyowner more flexibility than traditional whole life
             insurance.
           All of the statements are correct except for statement 3 because it is the mortality rate that
           determines the net premium for term insurance. Morbidity rates are used for disability insur-
           ance premiums.
        2. Identify circumstances for which the following types of life insurance would be
           most appropriate.
           ■ Term insurance
           Insurance is needed for a stated period, and relatively low premiums are desired.
           ■ Whole life insurance
           Fixed premium, permanent life insurance, and cash value are needed.
           ■ Variable life insurance
           Fixed premium, permanent life insurance, cash value, and policyowner investment direction
           are needed.
           ■ Universal life insurance
           Flexible premium, flexible death benefit, cash value, and potentially higher interest rates are
           goals.
           ■ Variable universal life insurance
           Flexible premiums, flexible death benefit, cash values, potentially higher growth or interest
           rates, and policyowner investment choices are goals.
        3. Compare the primary functions of life insurance and annuities.
           The primary function of life insurance is to create an estate or principal sum; the primary
           function of an annuity is to liquidate a principal sum. Both life insurance and annuities pro-
           tect against loss of income: life insurance furnishes protection against loss of income arising
           out of premature death, and an annuity provides protection against loss of income arising
           out of longevity.
244   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                          4. Discuss the following types of annuities:
                               Immediate versus deferred—an immediate annuity is one in which the first annuity payment
                               is due one payment interval from its purchase date; a deferred annuity provides income at
                               some future date.
                               Flexible premium versus single premium—a flexible premium annuity allows the insured the
                               option to vary premium deposits; a single premium annuity is purchased with a single lump
                               sum.
                               Fixed versus variable—with a fixed annuity, the insurer agrees to credit a specified inter-
                               est rate over a stated period; variable annuities do not guarantee specific annuity payments
                               (however, they have a potential for greater returns).
                          5. Identify and briefly describe the features of a major medical plan.
                               Major medical expense plans contain a coinsurance provision whereby the plan will pay
                               only a specified percentage of the covered expenses that exceed the deductible. Many major
                               medical contracts contain a lifetime maximum that applies to all medical expenses paid
                               (after the application of deductibles and coinsurance) during the entire period an individual
                               is covered under the contract.
                          6. Identify and describe the features of a long-term disability insurance policy.
                               Disability income policies generally have an elimination period before benefit payments
                               begin, and most insurers give the purchaser an option to select the duration of this period.
                               When selecting the elimination period for a disability income policy, the purchaser should
                               consider the ability to pay living costs and other expenses during that period and whether
                               other sources of funds are available during short-term disabilities.
                          7. Comment on the need for long-term care insurance.
                               Private medical expense insurance policies (both group and individual), in some cases, pro-
                               vide coverage only if a person also needs medical care; however, benefits are not provided if
                               a person is merely old and needs assistance. Medicare is inadequate because it does not cover
                               custodial care.
                          8. Frank age 45, is married to Julie. Frank makes $120,000 per year. He has 2
                             children, ages 9 and 10. He pays income taxes of $26,000 per year and FICA
                             taxes of $5,000 per year. Frank consumes $20,000 per year of the family’s
                             expenses. He expects raises of 4% and plans to retire at age 65. He expects infla-
                             tion to be 3%. Calculate the amount of life insurance needed using the human
                             life value approach:
                                Step 1: Calculate the family's share of earnings (FSE).
                                FSE = Annual earnings less taxes and Frank's personal consumption =
                                $120,000 – $31,000 – $20,000 = $69,000
                                Step 2: Calculate Frank's work life expectancy (WLE).
                                WLE = Expected age of retirement – current age = 65 – 45 = 20
                                Step 3: Calculate the future value of the family's share of earnings (FSE) over
                                Franks' work life expectancy (WLE).
                                PMT = $69,000
                                i = 4%
                                n = 20
                                FV = $2,054,687
                                Step 4: Determine human life value (HLV)
                                FV = $2,054,687
                                i = 3%
                                n = 20
                                PV = $1,137,630 = HLV
                                                                          Chapter 9 | Managing Life, Health, and Disability Risks       245


                           9. Describe the distinguishing features of whole life, universal life, variable life,
                              and variable universal life in terms of premium amount, death benefit, the poli-
                              cyowner’s control over investment, and the expected rate of return from the cost
                              value invested.
                                         Whole                                                         Variable         Equity indexed
                    Term life        (ordinary) life     Universal life         Variable life        universal life      universal life
Premium          Increasing or      Fixed; may          Adjustable at         Fixed; may           Adjustable at        Adjustable at
amount           level              decrease if divi-   policyowner’s         decrease if earn-    policyowner’s        policyowner’s
                                    dends are used      discretion, sub-      ings used to         discretion, sub-     discretion, sub-
                                    to reduce pre-      ject to minimum       reduce               ject to minimum      ject to minimum
                                    miums               and maximum           premiums             and maximum          and maximum
                                                        limits                                     limits; required     limits; the maxi-
                                                                                                   premiums may         mum required
                                                                                                   increase or          premium is
                                                                                                   decrease based       based on the
                                                                                                   on investment        minimum guar-
                                                                                                   performance of       anteed return
                                                                                                   subaccounts
Death benefits Fixed                Fixed; will         Option A: Level       Has a guaran-        No long-term         No long-term
                                    increase if divi-   (increases at         teed minimum         guarantee            guarantee
                                    dends are used      DEFRA corridor)       but can increase
                                                                                                   No lapse riders      No lapse riders
                                    to purchase                               if investment
                                                        Option B:                                  can be pur-          can be pur-
                                    paid-up addi-                             experience on
                                                        Increases by                               chased for a         chased for a
                                    tions                                     cash value is
                                                        amount of cash                             limited number       limited number
                                                                              favorable
                                                        value                                      of years.            of years
                                                                                                   Option A: Level      Option A: Level
                                                                                                   (increases at        (increases at
                                                                                                   DEFRA                DEFRA
                                                                                                   corridor)            corridor)
                                                                                                   Option B:            Option B:
                                                                                                   Increases by         Increases by
                                                                                                   amount of cash       amount of cash
                                                                                                   value                value
Policyowner’s    N/A                None                None                  Complete             Complete             None
control over
cash value
investments
Rate of return   N/A                Fixed; may also     Minimum guar-         No minimum           No minimum           Minimum guar-
on cash value                       pay dividends,      anteed rate, but      guarantee, but       guarantee, but       antee Lower
investment                          which vary          may be higher         positive invest-     positive invest-     than standard
                                                        depending on          ment experience      ment experience      Universal Life
                                                        current interest      can yield lofty      can yield lofty
                                                        rates                 returns              returns
Use              Limited resourc-   Maximum             No investment         Requires invest-     Requires invest-     Requires a cer-
                 es, large and/or   guarantees,         responsibil-          ment responsi-       ment responsi-       tain level of risk
                 temporary need,    minimum flex-       ity, maximum          bility, minimal      bility, moderate     tolerance to
                 no lifetime cov-   ibility, lifetime   flexibility, life-    flexibility, life-   flexibility, life-   hold through
                 erage              coverage            time coverage         time coverage        time coverage        down markets
                                                        (requires disci-                           (requires disci-
                                                                                                                        Lifetime cover-
                                                        plined funding)                            pline funding
                                                                                                                        age (requires
                                                                                                   and reasonable
                                                                                                                        disciplined
                                                                                                   investment per-
                                                                                                                        funding and
                                                                                                   formance)
                                                                                                                        reasonable
                                                                                                                        performance of
                                                                                                                        the underlying
                                                                                                                        index)
246   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                         10. Calculate the amount of money an insurance will pay if:
                               ■ the surgeon’s charge is $12,500;
                               ■ there is a 80/20 coinsurance clause;
                               ■ the deductible is $500; and
                               ■ the usual and customary charge for this surgery is $10,000.
                               The major medical policy will pay $7,600 (10,000 – 500 = 9,500 × .80).
                         11. Briefly explain the purpose of an elimination period in a long-term disability
                             policy.
                               To reduce unnecessary small claims and moral hazards, an elimination or waiting period of
                               one month to one year from the date of disability is included in a disability income policy.
                               During this waiting period, disability income benefits are not paid.
                         12. Differentiate between an HMO and a PPO.
                               An HMO assumes the responsibility and risk of providing a broad range of services to
                               members, including preventive medical services, such as check-ups and mammograms, in
                               exchange for a fixed monthly or annual enrollment fee. HMOs usually allow the members
                               very little choice of service providers. PPOs are structured in much the same way as HMOs
                               with two main exceptions. First, members are allowed to use non-PPO providers, although
                               they will be required to pay higher deductibles and coinsurance than required when they
                               use PPO doctors. Second, primary care doctors (as well as specialists) are paid on a fee-for-
                               service basis rather than as employees under the usual HMO. PPOs offer insureds a greater
                               choice of health care providers than most HMOs. Many find the HMO concept objection-
                               able because benefits are not provided if the covered person uses a doctor outside the HMO’s
                               network of providers (in other than an emergency). Although the insured pays more out of
                               pocket by going outside the network of preferred providers offered by a PPO, medical ben-
                               efits are still payable.
                         13. What are the qualifying events that allow for COBRA benefits? What is the
                             maximum benefit period for each qualifying event?
                               Death of the covered employee, termination of the employee (for any reason other than
                               gross misconduct, including quitting), reduction of employee’s hours from full time to part
                               time, separation of covered employee from spouse, employee becomes eligible for Medicare,
                               and a dependent child is no longer eligible for coverage under the employee’s plan, as would
                               be the case when the child left school, reached a certain age, or married.

                                Maximum benefit period:
                                Termination or part-time status: 18 months*
                                Death of covered employee: 36 months
                                Divorce or legal separation: 36 months
                                Loss of dependent status: 36 months
                                Medicare eligibility: 36 months
                                * Up to 29 months if employee meets Social Security definition of disabled or up to 36 months if the
                                beneficiary experiences, during a period of COBRA coverage, a second COBRA qualifying event.
                                                        Chapter 9 | Managing Life, Health, and Disability Risks   247




PROBLEMS AND SOLUTIONS
           PROBLEM 1
           Julian, age 27, has two children, ages 4 and 3, from his first marriage. He is now mar-
       ried to Marie. The children live with their mother, Alice. Julian and Marie each make
       $26,000 per year and have recently bought a house for $100,000, with a $95,000 mort-
       gage. They have the following life, health, and disability coverage:

        Life insurance:
                                                           Policy A              Policy B            Policy C
        Insured                                            Julian                Julian              Marie
        Face amount                                        $250,000              $78,000             $20,000
        Type                                               20-year level term    Group term          Group term
        Annual premium                                     $250                  $156                $50
        Who pays premium                                   Trustee               Employer            Employer
        Beneficiary                                        Trustee1              Alice               Julian
        Policyowner                                        Trust                 Julian              Marie
        1Children are beneficiaries of the trust required by divorce decree.


           Health insurance:
           Julian and Marie are covered under Julian’s employer plan, which is a PPO plan with
       a $500 in-network deductible per person per year and a $1500 nonnetwork deductible
       per person per year, an in-network 80/20 coinsurance clause with a family annual out-
       of-pocket maximum of $2,500, and an out-of-network 60/40 coinsurance clause with a
       family out-of-pocket maximum of $4,500. The PPO has a lifetime benefit maximum of
       $1 million per person.
            Long-term disability insurance:
          Julian is covered by an “own occupation” policy with premiums paid by his employer.
       The benefit equals 60% of his gross pay after a 180-day elimination period. The policy
       covers both sickness and accidents. The benefit period is five full years (60 months).
       Marie is not covered by disability insurance.
        1. Assume that Julian dies. Who would receive the proceeds of the insurance
           policies?
            As beneficiaries of the trust, Julian’s children would receive the proceeds from Policy A, and
            his ex-wife would receive the proceeds from Policy B. Although they are divorced, she is the
            named beneficiary and the proceeds will pass to her by operation of law. If the students have
            already covered estate planning, they may be more apt to see the distinction.
        2. Does Julian have adequate life insurance?
            No, Julian does not have adequate insurance because nothing will go to Marie in the event
            he predeceases her.
248   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                          3. Is Julian’s health and disability adequate? If not, why not?
                               Julian’s health insurance may not be adequate because of the low lifetime limit. If he were
                               ever injured severely, he could easily wipe out the lifetime limit. His disability insurance
                               may also not be adequate because his employer is paying the premium. Because the benefits
                               are taxable (due to the employer-paid premiums), 60% of gross pay coverage may not be
                               enough. Another issue that should be considered is the 180-day elimination period. If he
                               does not have enough liquid assets to cover him until the end of the elimination period, he
                               may have financial difficulty.
                          4. Should Marie have disability insurance? Why or why not?
                               Yes, about 60% of her gross pay. Julian and Marie earn the same income and share expenses.
                               If she is disabled for a long time, they may have financial difficulties.
                          5. Are any of the premiums or benefits received from the life, health, or disability
                             insurance taxable to Julian and Marie?
                               A portion of Julian’s life insurance premiums that is paid by the employer will be taxable
                               because the benefit is over the $50,000 threshold. Any benefits paid out from Julian’s dis-
                               ability policy will also be taxable.

                              PROBLEM 2
                              Richard graduated from a state university with a Bachelor of Science degree in
                          accounting. He has been employed at Knoth & Cartez, a small local accounting firm
                          (50 employees) for almost seven years. He makes $31,000 per year. Richard has been mar-
                          ried to Marianne for six years. She graduated from a private university with a Bachelor
                          of Science degree in elementary education. She is employed as a fourth grade teacher at
                          Riverside Preparatory School. She makes $22,000 per year. Richard and Marianne have
                          three children: Carlos, age four; and twin girls, Maria and Anna, age two.
                               The Richards have the following insurance:
                               Health Insurance:
                               Health insurance is provided for the entire family by Knoth & Cartez. The family
                          is covered by an HMO. Doctor’s visits are $10 per visit, prescriptions are $5 for generic
                          brands and $10 for other brands, and there is no co-payment for hospitalization in semi-
                          private accommodations. Private rooms are provided when medically necessary. For emer-
                          gency treatment, a $50 copayment is required.
                              Life Insurance:
                              Richard has a $50,000 group term life insurance policy through Knoth & Cartez.
                          Marianne has a $20,000 group term policy through Riverside Preparatory School. The
                          owners of the policies are Richard and Marianne, respectively, with each other as the
                          respective beneficiary.
                               Disability Insurance:
                               Richard has disability insurance through the accounting firm. Short-term disability
                          benefits begin for any absence due to accident or illness over six days and continue for up
                          to six months at 80% of his salary. Long-term disability benefits are available if disability
                          continues over six months. If Richard is unable to perform the duties of his own current
                          position, the benefits provide him with 60% of his gross salary while disabled until recov-
                          ery, death, retirement, or age 65 (whichever occurs first). All disability premiums are paid
                          by Knoth & Cartez. Marianne currently has no disability insurance.
                                     Chapter 9 | Managing Life, Health, and Disability Risks   249


1. What happens to the family’s health insurance if Richard is terminated from his
   job? What are the alternatives?
   1. COBRA (18 months)
   2 Individual policy
   3. Marianne’s employer group policy
2. Does Richard have adequate life insurance?
   No. Richard only has $50,000 of coverage. Because he and Marianne have three children
   under five years old, they both need substantially more than $50,000 in insurance.
3. Does either of the group term policies cause taxable income to Richard and
   Marianne?
   No, the premiums paid by an employer for group term are excludible from income tax up to
   $50,000 of coverage.
4. Should Marianne have disability insurance?
   Yes, to replace her income.
250   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition



❚ ❚ CASE
                             Use the information provided to answer the owing questions regarding the Nelson
                          family.
                                               NELSON FAMILY CASE SCENARIO
                                                   DAVID AND DANA NELSON
                                                          As of 1/1/2010




❚ ❚ PERSONAL BACKGROUND AND INFORMATION
                              David Nelson (age 37) is a bank vice president. He has been employed there for
                          12 years and has an annual salary of $70,000. Dana Nelson (age 37) is a full-time home-
                          maker. David and Dana have been married for eight years. They have two children,
                          John (age 6) and Gabrielle (age 6), and are expecting their third child in 2 weeks. They
                          have always lived in this community and expect to remain in their current residence
                          indefinitely.


                          Insurance Information

                          Health insurance
                               The entire family is insured under David’s employer’s health plan (PPO). The plan
                          has no co-payment for preventive care, a $10 co-payment for primary care, a $30 co-pay-
                          ment for specialist visits, and a $100 emergency room co-payment. The ER co-payment is
                          waived if an insured is subsequently admitted to the hospital. For other covered expenses,
                          a $0 in-network deductible and a $500 out-of-network deductible apply, after which 80/20
                          coinsurance applies in network and 60/40 applies out of network. There is an annual stop-
                          loss limit of $20,000 in network and $30,000 out of network. The plan has an overall
                          lifetime maximum of $2,000,000 per family member, and the entire monthly premium of
                          $1,123.54 is paid by David’s employer.


                          Life insurance
                              David’s employer provides group term life insurance equal to two times his current
                          salary. The premium is paid entirely by his employer, and Dana is the primary beneficiary.
                          No contingent beneficiary is named.


                          Disability insurance
                              David’s employer also offers a contributory group long-term disability insurance
                          program toward which the employer contributes 60% of the $291.67 monthly premium.
                          David is a participant in the program, which provides a monthly disability income benefit
                          equal to 70% of his current salary, payable to age 65, provided that he remains disabled per
                          the policy’s “own occupation” definition of disability. David must satisfy a 90-day elimina-
                          tion period before he is eligible to begin receiving benefits.
                                                    Chapter 9 | Managing Life, Health, and Disability Risks   251


               David’s employer doesn’t offer dental or vision coverages, and the Nelsons have not
           obtained any form of individual dental or vision insurance benefits.



❚ ❚ RELEVANT EXTERNAL ENVIRONMENTAL INFORMATION
           ■❚   Mortgage rates are 6.0% for 30 years and 5.5% for 15 years, fixed.
           ■❚   Gross domestic product is expected to grow at less than 3%.
           ■❚   Inflation is expected to be 2.6%.
           ■❚   Expected return on investment is 10.4% for common stocks, 12.1% for small com-
                pany stocks, and 1.1% for US Treasury bills.
           ■❚   College education costs are $15,000 per year.
252      Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition



                                                    Dana and David Nelson
                                                Statement of Financial Position
                                                     December 31, 2009
ASSETS                                                                LIABILITIES AND NET WORTH
Cash/Cash Equivalents                                                 Current Liabilities
JT    Checking account                            $1,268       JT     credit cards                           $3,655
JT    Savings account                                 950      JT     JT mortgage on principal residence      1,370
      Total cash/cash eq                          $2,468       H      boat loan                               1,048
                                                                      Total Current Liabilities              $6,073
Invested Assets                                                       Long-Term Liabilities
W     ABC stock                                  $14,050       JT     mortgage on principal residence      $195,284
JT    Educational fund                            15,560       H      boat loan                              16,017
JT    401(k)                                      38,619              Total Long-Term Liabilities          $211,301
H     XYZ stock                                   10,000
Total Invested Assets                            $78,229
Personal Use Assets                                                   Total Liabilities                    $217,374
JT    Principal residence                      $250,000
JT    Automobile                                  15,000
H     Personal watercraft                         10,000              Net Worth                            $241,573
H     Boat B                                      30,000
W     Jewelry                                     13,500
JT    Furniture/household                         60,000
Total Personal Use Assets                      $378,500
Total Personal Use Assets                      $458,947               Total Liabilities and Net Worth      $458,947


                                  Notes to Financial Statements:
                             ■❚   Assets are stated at fair market value.
                             ■❚   The ABC stock was inherited from Dana’s aunt on November 15, 2002. Her aunt
                                  originally paid $20,000 for it on October 31, 2002. The fair market value at the
                                  aunt’s death was $12,000.
                             ■❚   Liabilities are stated at principal only.
                             ■❚   H = husband; W = wife; JT = joint tenancy
                                       Chapter 9 | Managing Life, Health, and Disability Risks   253


     1. The Nelsons wish to evaluate and update their life insurance coverage. David
        would like to have enough insurance to provide the family with 60% of his
        current salary. ABC stock and XYZ stock have average annual returns of 9%.
        The educational fund is invested 100% in US Treasuries. David’s 401(k)
        plan is invested 50% in a diversified common stock fund and 50% in a small
        company stock fund. Using the capital retention approach and an interest rate
        of 8% and ignoring Social Security benefits, how much additional life insur-
        ance do the Nelsons need? Evaluate David’s group term life insurance from an
        income tax perspective as well.
    The Nelsons have a net worth of $241,823 but only $78,229 of income-producing
assets.

ABC stock (9%)           =      9% × $14,050                          =          $1,264
XYZ stock (9%)           =      9% × $10,00                           =              900
Educational fund         =      1.1% × $15,560                        =              171
          401(k)         =      50% × 10.4% × $38,619                 =            2,008
          401(k)         =      50% × 12.1% × $38,619                 =            2,336
                                                                                 $6,679

    The Nelsons will receive $6,679 of income from their income-producing assets.
60% of David’s salary = 60% × $70,000 = $42,000. Life insurance will need to provide
$42,000 – $6,679 = $35,321 per year. Using the 8% interest rate, David needs $35,321
÷ 8% = $441,512 of life insurance. Because David already has $25,000 of coverage, the
Nelsons will need $441,512 – $25,000 = $416,512 of additional insurance.
2. Evaluate the Nelsons’ disability insurance coverage, and determine what
   portion of the policy premium is taxable and what portion of the benefit would
   be income taxable if received.
     Sixty percent of David’s income is $3,500 per month (60% × $70,000 ÷ 12). The ben-
efits received from disability would be $2,700 per month, which is much less than 60% of
David’s salary. So the amount of benefits should be increased to at least $3,500 per month.
The “own occupation” definition of disability is excellent. The benefit term, until age 65,
is appropriate. Because the disability policy only provides coverage for accidental injury,
David should add coverage for illness. The 30-day elimination period is appropriate given
the Nelsons’ low balance of liquid assets.
3. Assume that the Nelsons incurred the following medical expenses in 2010:
■❚   Six routine visits to Dana’s obstetrician = $900
■❚   Hospital and physician charges for delivery of third child = $10,600
■❚   Visits to pediatrician = $1,500
■❚   Regular dental cleanings performed by the hygienist = $300
■❚   David’s visit to the emergency room and subsequent surgery = $7,500
■❚   Follow-up visits to David’s doctor = $430
■❚   Vision check and purchase of prescription glasses = $385
    All services were received in network. What was the total cost to the Nelsons for
the above services?
254   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                              The Nelsons have major medical coverage with a $200 family deductible and an
                          80/20 coinsurance provision. Coverage for dental and optical care is not included in
                          major medical insurance. Thus, the dental cleanings ($300) and the vision check ($385)
                          will not be covered. The remaining expenses ($20,480) will be covered subject to the
                          deductible and coinsurance. Thus, the insurance will pay 80% × ($20,480 – $200) =
                          $16,224. The Nelsons must pay $20,480 – $16,224 + $300 + $385 = $4,941.
274    Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition




      DISCUSSION QUESTIONS AND SOLUTIONS
                            1. Describe the need for homeowners, auto, and umbrella liability insurance
                               coverages.
                                Many individuals in society either own or rent a dwelling. Within that dwelling are various
                                personally owned possessions. In addition, most individuals own at least one automobile.
                                Both of these property types represent a substantial portion of most people’s assets. Thus,
                                insurance on each is a critical concern in financial planning. Homeowners and automobile
                                insurance are package policies that provide both property and liability coverage in one con-
                                tract. The personal umbrella policy provides a layer of personal liability protection above
                                the coverages provided in the homeowners and automobile policies in the unfortunate event
                                that those policies do not provide adequate compensation to injured parties.
                            2. List and define the basic coverages provided by a homeowners policy.
                                Coverage A: Dwelling—covered losses to the dwelling and other structures are paid on the
                                basis of replacement cost with no deduction for depreciation.
                                Coverage B: Other Structures—paid on the basis of replacement cost; limit is typically 10
                                percent of the coverage A limit.
                                Coverage C: Personal Property—actual cash value (ACV) coverage with a limit typically
                                equal to 50% of the coverage A limit.
                                Coverage D: Loss of Use—a combination of additional living expenses and loss of rental
                                income generally limited to a maximum of 20% of the Coverage A limit.
                                Coverage E: Personal Liability—protects the named insured and all resident family members
                                against liability for bodily injuries and property damage they or their resident premises cause
                                others to suffer; minimum limit coverage is $100,000 per occurrence.
                                Coverage F: Medical Payments to Others—this coverage pays necessary medical expenses of
                                others that result from bodily injury.
                            3. List the various homeowners forms.
                                HO-2: Broad Form (named perils)
                                HO-3: Special Form (open perils)
                                HO-4: Tenants or Renters
                                HO-5: Comprehensive Form
                                HO-6: Condominium Owners
                                HO-8: Modified Form
                            4. Explain the contractual options and provisions in homeowners insurance.
                                The student should discuss some of the provisions listed under Homeowners Insurance
                                Contractual Conditions. The student also may wish to discuss the endorsements or limita-
                                tions within each section of coverage. Examples of appropriate topics include: duties after
                                a loss, loss settlement, loss to a pair or a set, appraisal, other insurance, suits against the
                                insurance company, settlement at insurer’s option, loss payment, abandonment of property,
                                mortgage clause, no benefit to bailee, recovered property, volcanic eruption period, limit of
                                liability, concealment or fraud, cancellation and nonrenewal, assignment, and subrogation.
                                           Chapter 10 | Personal Property and Liability Insurance    275


 5. List and define the basic coverages provided by the personal automobile insur-
    ance policy (PAP).
    Part A: Liability Coverage—provides liability protection for bodily injuries and property
    damages caused by an auto accident for which an insured becomes legally liable
    Part B: Medical Payments—no-fault, first-party coverage designed to pay for bodily injuries
    sustained in an auto accident
    Part C: Uninsured Motorists—acts as liability insurance for an uninsured or underinsured
    motorist
    Part D: Coverage for Damage to Your Auto—provides direct damage coverage on your cov-
    ered auto plus any nonowned auto
 6. Explain the various contractual options and provisions in a personal automobile
    insurance policy (PAP).
    This question attempts to familiarize the student with the sections of the PAP. Appropriate
    topics would be liability coverage (covered persons and autos, exclusions, increased limits in
    another state, loss sharing with other coverage), medical payments (covered individuals and
    exclusions), uninsured motorists (coverage and exclusions), coverages for damage to your
    auto (two coverages available: collision and comprehensive), duties after an accident, or loss
    and general provisions.
 7. Explain the distinguishing characteristics of a personal umbrella policy (PUP).
    The personal umbrella policy (PUP) is designed to provide a catastrophic layer of liability
    coverage on top of the individual’s homeowners and automobile insurance policies. The
    PUP provides the insured with a large amount of coverage at an affordable price. The cover-
    age provided is generally quite broad and may even provide coverages in addition to those
    provided by the underlying policies. The PUP might provide personal injury coverage (for
    defamation of character, false arrest, and so forth) even though the underlying HO policy
    does not. Where these additional coverages are provided, the insured is usually required to
    pay a self-insured retention (SIR) for each loss. The SIR is similar to a deductible. Where
    both the umbrella and an underlying policy cover a loss, the umbrella does not pay claims
    until the underlying coverage has exhausted its limits. From there, the umbrella picks up
    with no SIR imposed on the insured.
 8. What type of coverage does Section 1 of a homeowners policy provide?
    Section 1 provides the four coverages: dwelling, other structures, personal property, and loss
    of use. Additional coverage, which includes debris removal, damage to trees, and credit card
    loss, is also included in Section 1 coverage.
 9. What type of coverage does Section 2 of a homeowners policy provide?
    Section 2 of the homeowners policy provides coverage for personal liability and medical pay-
    ments to others.
10. Are intentional acts usually covered by insurance?
    If a loss is discovered to be an intentional act on the part of an insured, it is not covered.
276    Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition




      EXERCISES and SolutionS
                            1. What are the three types of property and liability loss exposures facing families
                               and businesses?
                                Property loss exposures, which include losses to either real or personal property; liability loss
                                exposures; and consequential or indirect loss exposures that arise as a result of property or
                                liability losses
                            2. What is a named-perils policy?
                                A policy that specifically lists the covered perils in the insurance policy.
                            3. Why is it that property insurance policies only pay for the policyowner’s insurable
                               interest in a loss?
                                The insurable interest rule is used to deter the insured from damaging property that he has
                                no interest in just to collect the insurance.
                            4. How do property insurance policies determine how losses will be valued?
                                The insurance policy may determine valued losses in one of the following ways: replacement
                                value or actual cash value. Each available option should be detailed in the policy.
                            5. List some examples of types of property with limited coverage under a typical
                               homeowners policy.
                                Examples include:
                                ■ $200—money, bullion, coin collections, and bank notes
                                ■ $1,500—securities, bills, evidence of debt, airline ticket, and manuscripts
                                ■ $1,500—theft of jewelry, watches, gems, precious metals, and real furs
                                ■ $1,500—watercraft, including trailers (not boat affiliated) and equipment
                                ■ $2,500—theft of firearms
                                ■ $2,500—theft of silverware, goldware, pewterware, and similar property
                                ■ $500—loss of business use property not on premises
                                ■ $2,500—loss of business use property on premises
                                ■ $1,500—loss of electronic apparatus
                            6. List two major exclusions found in homeowners insurance policies pertaining to
                               real property.
                                General exclusions include:
                                ■ Earthquakes (movement of the ground)
                                ■ Ordinance of law
                                ■ Damage from water (flooding)
                                ■ War
                                ■ Nuclear hazards
                                ■ Power failure
                                ■ Intentional act
                                ■ Neglect
                                           Chapter 10 | Personal Property and Liability Insurance   277


 7. List the 18 perils that constitute broad coverage.

       1. Fire
       2. Lightning
       3. Windstorm
       4. Hail
       5. Riot or civil commotion
       6. Aircraft
       7. Vehicles
       8. Smoke
       9. Vandalism or malicious mischief
      10. Explosion
      11. Theft
      12. Volcanic eruption
      13. Falling objects
      14. Weight of ice, snow, and sleet
      15. Accidental discharge or overflow of water or steam
      16. Sudden and accidental tearing apart, cracking, burning, or bulging of a steam,
          hot water, air conditioning, or automatic fire protective sprinkler system, or
          from within a household appliance
      17. Freezing of a plumbing, heating, air conditioning, or automatic fire sprinkler
          system, or of a household appliance
      18. Sudden and accidental damage from artificially generated electrical current

 8. If Joe is injured in an automobile accident, will his own auto policy pay for his
    medical injuries?
    Yes, medical payments are a no-fault coverage designed to pay for bodily injuries sustained in
    an auto accident.
 9. Differentiate between the HO-2 and the HO-3 form of homeowners insurance.
    The HO-2 policy is a broad form policy that covers only the 18 listed perils. The HO-3
    policy is a special form policy that covers all perils except those that are excluded.
10. Jan rents an apartment and has $40,000 contents coverage. If she is unable to
    occupy her apartment due to a negligent fire, for how many months could she rent
    a $700 per month apartment if her damaged apartment rented for $600 per month?
    Jan would be allowed up to 30% of her content coverage ($12,000) for loss of use. Loss of
    use covers any additional living expenses incurred due to Jan having to live elsewhere, in
    this case $100 ($700 – $600) per month. This would last for 120 months at $100 per month.
278   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                         11. Patrice lives in Nebraska where she carries the state-mandated minimum liability
                             insurance on her car (10/25/10) through her personal automobile policy (PAP).
                             She is driving through Texas and has a wreck. Texas requires minimum liability
                             insurance of 25/50/20. She injures Sherri in an amount equal to $30,000 and
                             Sherri’s vehicle in an amount of $15,000. How much will Sherri collect from
                             Patrice’s PAP?
                               Because the PAP will automatically provide the increased limits required by state law, Sherri
                               will be able to collect $25,000 of bodily injury and $15,000 in property damage for a total of
                               $40,000.
                         12. Pat and Matt are fraternity brothers who frequently drive each other’s cars.
                             Their automobiles are insured as follows:


                                                        Insured        Insurance Company    Amount
                                                          Pat                 XYZ Co.       25/50/10
                                                         Matt                 All Auto     100/300/25

                               Pat is negligent while driving Matt’s car and has an accident, and the bodily injury loss
                               to the other party involved in the accident is $30,000. Which insurer will pay, and how
                               much will be paid?
                               When more than one auto policy covers a loss, the general rule is that insurance on the
                               automobile is primary and insurance on the driver is excess. Therefore, Matt’s insurance will
                               pay the entire $30,000.
                                                  Chapter 10 | Personal Property and Liability Insurance   279




PROBLEMS and SolutionS
        1. Jimmy and Mary Sue, age 28 and 27 respectively, are married and have net
           worth of $100,000. They both work, Jimmy has a 1980 Chevy truck, and Mary
           Sue has a 1994 Toyota Corolla. They also own a 1964 Indian motorcycle. They
           rent an apartment and have the following automobile and renter’s insurance
           policies:
           Renter's insurance:
           ■ HO-4 renter’s policy without endorsements.
           ■ Content coverage − $25,000; liability − $100,000.

           Automobile insurance:
           ■ Both car and truck


                             Type                                 PAP
                             Bodily injury                        $25,000/$50,000
                             Property damage                      $10,000
                             Medical payments                     $5,000 per person
                             Physical damage                      Actual cash value
                             Uninsured motorist                   $25,000/$50,000
                             Comprehensive deductible             $500
                             Collision deductible                 $500
                             Premium (annual)                     $2,500


           What risk exposures are not covered by the HO-4 policy?
           Open perils and replacement value on contents
           Comment on the efficiency and effectiveness of the PAP.
           Premium is too high; comprehensive and collision may not be appropriate.
           Liability limits are probably state-mandated minimums and are inadequate.
           Is the motorcycle covered under the PAP?
           Motorized vehicles with fewer than four wheels are not covered; a separate policy to cover
           the motorcycle is needed.
           Do they have adequate liability coverage? If not, what would you suggest?
           No, they do not have adequate liability coverage.
           HO—$100,000
           PAP—$25,000/$50,000
           No motorcycle
           Should increase limits on primary insurances and consider purchasing a $1,000,000 PUP
        2. The Nicholsons recently purchased a fabulous stereo system (FMV $10,000).
           They asked and received permission to alter their apartment to build speakers
           into every room. The agreement with the landlord requires them to leave the
           speakers if they move because they are permanently installed and affixed to the
280   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                               property. The replacement value of the installed speakers is $4,500, and the
                               noninstalled components are valued at $5,500. The cost of the entire system was
                               $10,000. The Nicholsons have an HO-4 policy with $25,000 of content cover-
                               age and $100,000 of liability coverage.
                               If the Nicholsons were burglarized and had their movable stereo system compo-
                               nents stolen, would the burglary be covered under the HO-4 policy, and if so, for
                               what value?
                               Yes, the loss would be covered, but only to the actual cash value (cost minus depreciation)
                               less the deductible.
                               If there was a fire in the Nicholsons’ apartment building and their in-wall speaker
                               system was destroyed, would they be covered under the HO-4 policy, and, if so, to
                               what extent?
                               Yes, the loss would be covered but would be limited to $2,500 (10% of personal property)
                               under the building additions provision.
                               If a fire forces them to move out of their apartment for a month and rent else-
                               where at a higher cost, would the HO-4 policy provide any coverage?
                               Yes, it would provide coverage for loss of use up to $7,500 (30% of content coverage).
                           3. Ken and Mary Claire Powell, both age 40, own their own home, with the land
                              valued at $80,000, and the dwelling valued at $150,000. They have a total
                              net worth of $550,000. They have the following property/liability insurance
                              coverages:
                               Homeowners Insurance
                               The Powells currently have an HO-3 policy with a replacement value endorse-
                               ment on contents. The policy provides open-perils coverage. The deductible is
                               $250, and the premium is $533.60 per year.
                               The building coverage is $100,000, contents $50,000, and liability $100,000.
                               Automobile Insurance
                               The Powells have full coverage on both cars, including the following:
                               1. $100,000 bodily injury for one person
                               2. $300,000 bodily injury for all persons
                               3. $50,000 property damage
                               4. $100,000 uninsured motorists
                               Deductibles are:
                               1. $500 comprehensive
                               2. $1,000 collision
                               This insurance includes medical payments, car rentals, and towing.
                               The cost of the auto insurance is $2,123.50 per year because of the number of
                               speeding tickets Mary Claire has received.
                               The Powells suffer a burglary and lose personal property items purchased for
                               $20,000 and having a replacement value of $27,000. How much will the insur-
                               ance company pay?
                               $27,000 – $250 = $26,750
                                    Chapter 10 | Personal Property and Liability Insurance   281


If a fire destroys two-thirds of their house and the loss is $100,000, how much
will the insurance company pay?
Coinsurance requirement of 80%:
$150,000 × .80 = $120,000 (coverage the Powells should have carried)
$100,000 coverage carried
$100,000/$120,000 × $100,000 = $83,333 – $250 = $83,083
Do the Powells have adequate liability coverage?
No, HO is only $100,000; auto is 100/300/50; net worth is $550,000.
What would you recommend regarding liability coverage?
They should increase the limits on their homeowners and auto policies and consider pur-
chasing a $1,000,000 PUP.
While Mary Claire’s car was parked in a parking lot next to a playground, a
young student missed a ball being thrown, and it dented the hood of Mary
Claire’s car. The damage was estimated to cost $1,840 to repair. How much will
the insurer pay?
The insurance company will pay $1,340 because it falls under comprehensive coverage.
282   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition



❚ ❚ CaSeS and SolutionS
                          The Bannisters
                              Derek Bannister, age 26, has been employed for five years at a computer store as a
                          salesperson and trainer. He earns $30,000 per year. His wife, Olga Bannister, age 26, is a
                          German citizen and is employed as a floral designer for a local florist. She earns $28,000
                          per year. Derek and Olga have been married for two years and have one child, Prissy,
                          age 1.


                          Insurance Information:
                                                                        Life Insurance
                                      Insured                           Derek
                                      Owner                             Derek
                                      Beneficiary                       Olga
                                      Face amount                       $50,000
                                      Cash value                        $0
                                      Type of policy                    Term
                                      Settlement options                Lump sum
                                      Premium                           Employer-provided

                                                                        Health Insurance
                                      Premium                           Employer-provided for Derek; Olga and Prissy are
                                                                        dependents under Derek’s policy
                                      Coverage                          Major medical with a $1,000,000 lifetime limit
                                                                        Dental coverage is not provided
                                      Deductible                        $250 per person (3-person maximum)
                                      Family out-of-pocket limit        $2,500

                                                                        Disability Insurance
                                      Neither Derek nor Olga has disability insurance


                                                                        Automobile Insurance
                                      Premium                           $1,000 total annual premium for both vehicles
                                      Bodily injury and property        $10,000/$25,000/$5,000 for each vehicle
                                      damage
                                      Comprehensive                     $250 deductible
                                      Collision                         $500 deductible

                                                                        Renter’s Insurance
                                      Type                              HO-4
                                      Contents coverage                 $35,000
                                      Premium                           $600 annually
                                      Deductible                        $250
                                      Liability                         $100,000
                                      Medical payments                  $1,000 per person
                                                                   Chapter 10 | Personal Property and Liability Insurance   283


                                 Homeowners 04 Policy Declaration Page
Policy Number: H04-123-ZA-996
Policy Period: 12:01 a.m. Central Time at the residence premises
From: January 1, 2009                                                                     To: December 31, 2009
Name insured and mailing address:
Derek and Olga Bannister
123 Raleigh Way, Apartment 8
Anytown, State 00001

The residence premises covered by this policy is located at the above address unless otherwise indicated.
Same as above.

Coverage is provided where a premium or limit of liability is shown for the coverage.

Section I Coverages                                        Limit of Liability             Premium
A. Dwelling                                                N/A                            N/A
B. Other Structures                                        N/A                            N/A
C. Personal property                                       $35,000                        $475
D. Loss of use                                             N/A                            N/A
SECTION II COVERAGES
A. Personal liability: each occurrence                     $100,000                       $100
B. Medical payments to others: each occurrence             $1,000                         $ 25
Total premium for endorsements listed below
                                                           Policy Total                   $600
Forms and endorsements made part of this policy:
Number                           Edition                   Date                   Title                    Premium
Not applicable.
DEDUCTIBLE - Section I: $250
In case of a loss under Section I, we cover only that part of the loss over the deductible stated.
Section II: Other insured locations: Not applicable.
[Mortgagee/Lienholder (Name and address)]
Not applicable.
Countersignature of agent/date                             Signature/title - company officer


                        While on a vacation in Colorado, the Bannisters experienced several unfortunate incidents.
                        ■ A deer collided with their car, causing $800 worth of damage.
                        ■ Derek rented a motorcycle. While riding the motorcycle, his wallet was stolen, but he
                          thought he had lost the wallet on the mountain during a fall, so he did not report the loss
                          to the credit card company until he returned home.
                        ■ Derek, not experienced driving in the mountains, collided with another motorcycle on
                          the road causing damage to both motorcycles and injuring Derek. The driver of the other
                          motorcycle, Oscar, suffered a broken arm.
                        ■ Upon returning home, the Bannisters discovered that their apartment building had been
                          destroyed by fire.
                   1. How much will the insurance company pay to have the front of the car repaired
                      from the collision with the deer?
                        $800 – $250 comprehensive deductible = $550
284   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                           2. The fire that destroyed the apartment building also destroyed all of their personal
                              property. Although the depreciated or actual cash value of all their property is
                              $8,000, it would cost the Bannisters about $37,000 to replace all of their lost
                              items. How much will the insurance company pay for this loss?
                               Actual cash value less the deductible ($8,000 – $250 = $7,750)
                           3. Derek’s collision with the motorcycle caused $2,000 of damage to Oscar’s motor-
                              cycle. Will the HO-4 liability policy cover the loss?
                               No coverage is provided for motorized vehicles with fewer than 4 wheels.
                           4. Oscar, the motorcycle owner, suffered $350 in emergency medical expense to
                              reset his broken arm caused by the incident. Will the HO-4 cover the loss?
                               No, the loss is a result of a motorcycle accident, and the motorcycle is not covered.
                           5. In the motorcycle accident, Derek suffered medical expenses of $1,850. Is Derek
                              covered by the HO-4 for this loss?
                               The HO-4 policy will not cover Derek because he is the insured, but the major medical
                               policy will cover him after the $250 deductible.
                           6. What deficiencies do you think are in the Bannisters’ overall insurance program?
                               Life insurance is too low on Derek, and Olga should have a life insurance policy.
                               Both Derek and Olga need disability insurance.
                               The lifetime limit on the health insurance coverage is too low; it needs to be at least
                               $1,000,000.
                               A replacement value endorsement on the HO-4 policy is needed.
                               They may need a personal liability umbrella policy.


                          The Nelsons
                              David Nelson (age 37) has been employed as a bank vice president for 12 years and
                          has an annual salary of $70,000. Dana Nelson (age 37) is a full-time homemaker. David
                          and Dana have been married for eight years. They have two children, John (age 6) and
                          Gabrielle (age 3), and are expecting their third child in two weeks. They have always
                          lived in this community and expect to remain indefinitely in their current residence.


                          Insurance Information

                              Health Insurance. The entire family is insured under David’s employer’s health plan
                          (PPO). The plan has no co-payment for preventive care, a $10 co-payment for primary
                          care, a $30 co-payment for specialist visits, and a $100 emergency room co-payment.
                          The emergency room co-payment is waived if an insured is subsequently admitted to
                          the hospital. For other covered expenses, a $0 in-network deductible and a $500 out-
                          of-network deductible apply, after which 80%/20% coinsurance applies in network and,
                          60%/40% applies out of network. There is a stop-loss limit of $20,000 annually in net-
                          work and $30,000 annually out of network. The plan has an overall lifetime maximum of
                          $2,000,000 per family member, and the entire monthly premium of $1,123.54 is paid by
                          David’s employer.
                                      Chapter 10 | Personal Property and Liability Insurance   285


    Life Insurance. David’s employer provides group term life insurance equal to two
times David's current salary. The premium is paid entirely by his employer, and Dana is
the primary beneficiary. No contingent beneficiary is named.

     Disability Insurance. David’s employer also offers a contributory group long-term
disability insurance program toward which the employer contributes 60% of the $291.67
monthly premium. David is a participant in the program, which provides a monthly dis-
ability income benefit equal to 70% of his current salary, payable to age 65, provided that
he remains disabled per the policy’s “own occupation” definition of disability. David must
satisfy a 90-day elimination period before he is eligible to begin receiving benefits.
     David’s employer doesn’t offer dental or vision coverage and the Nelsons have not
obtained any form of individual dental or vision insurance benefits.

    Homeowners Insurance. The Nelsons have an HO-3 policy with replacement cost
on contents. There is a $250 deductible. The annual premium is $950.

     Automobile Insurance. The Nelsons have automobile liability and bodily injury
coverage of $100,000/$300,000/$100,000. They have both comprehensive coverage and
collision. The deductibles are $250 (comprehensive) and $500 (collision). The annual
premium is $900.
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                                                                      Dana and David Nelson
                                                                  Statement of Financial Position
                                                                           12/31/2009
                                    ASSETS                                             LIABILITIES AND NET WORTH
                                    Cash/Cash Equivalents                              Current Liabilities
                                    JT   Checking Account                 $1,268       JT   Credit Cards                        $3,655
                                    JT   Savings Account                    $950       JT   Mortgage on Principal Residence     $1,370
                                    Total Cash/Cash Equivalents           $2,218       H    Boat Loan                           $1,048
                                                                                       Total Current Liabilities                $6,073
                                    Invested Assets                                    Long-Term Liabilities
                                    W ABC Stock                          $14,050       JT   Mortgage on Principal Residence $195,284
                                    JT   Educational Fund                $15,560       H    Boat Loan                          $16,017
                                    H    401(k)                          $38,619       Total Long-Term Liabilities            $211,301
                                    H    XYZ Stock                       $10,000
                                    Total Invested Assets                $78,229
                                    Personal-Use Assets                                Total Liabilities                      $217,374
                                    JT   Principal Residence           $250,000
                                    JT   Automobile                      $15,000
                                    H    Personal watercraft             $10,000       Net Worth                              $241,573
                                    H    Boat B                          $30,000
                                    W Jewelry                            $13,500
                                    JT   Furniture/Household             $60,000
                                    Total Personal-Use Assets          $378,500
                                    Total Assets                       $458,947        Total Liabilities and Net Worth        $458,947

                               Notes to financial statements:
                               ■ Assets are stated at fair market value.
                               ■ The ABC stock was inherited from Dana’s aunt on November 15, 2002. Her aunt
                                 paid $20,000 for it on October 31, 2002. The fair market value at the aunt’s death was
                                 $12,000.
                               ■ Liabilities are stated at principal only.
                               ■ H = husband; W = wife; JT = joint tenancy
                                          Chapter 10 | Personal Property and Liability Insurance   287


1. Evaluate the Nelson’s personal property and liability insurance coverage.
   Homeowners insurance: The Nelsons have open-perils coverage on the dwelling and
   broad-perils coverage on personal property. They have replacement cost on contents, so
   their policy is sufficient.
   Automobile insurance: The Nelsons have excellent liability coverage. Their automobile is
   worth $15,000, so the coverage for comprehensive and collision is appropriate.
   Other personal property and liability: Additional property insurance or a rider to the
   homeowners insurance should be purchased for the jewelry. The jewelry is worth $13,500,
   and the HO-3 policy will cover only $1,500. Property and liability coverage should be
   obtained for the personal watercraft and the boat. The Nelsons have substantial net worth,
   so a personal liability policy also should be purchased.
2. What business and professional insurance coverage(s) may be relevant to the
   Nelsons?
   David Nelson is a bank vice president. Directors and officers errors and omissions insurance
   may be relevant.
3. The Nelson’s homeowners insurance provides dwelling coverage for $180,000
   with an 80% coinsurance requirement. On December 31, 2009, a stampeding
   herd of cattle ran through their house, causing $100,000 of damage to the home
   and $40,000 of damage to furniture and other personal property. How much of
   the $140,000 of damage will be paid for by their insurance? Assume the replace-
   ment value for the home is $240,000.
   Damage by a herd of cattle is not a listed broad peril, so the damage to the personal property will
   not be covered. Because the Nelsons have open-perils coverage on the dwelling, the damage to
   the home will be covered. According to the coinsurance requirement, the insurer will pay:
             Insurance                               $180,000
                           × amount of loss =                        × $100,000 = $93,750
            Coinsurance                         80% × $240,000

   The deductible is $250, so the insurer will pay $93,750 – $250 = $93,500.
4. A deer ran into the Nelson’s car while they on a trip to the supermarket. The
   damage to the car was $3,000, and Dana, the driver, required $1,200 of medical
   care. What portion of the accident expenses will be Dana and David's responsi-
   bility to pay, if any?
   Because a deer hit the car, the property damage will be covered under comprehensive coverage.
   The Nelson’s deductible is $250. Therefore, the automobile insurer will pay $3,000 – $250 =
   $2,750. The Nelsons do not have medical payment coverage under their automobile insur-
   ance, so Dana’s injuries will be covered by their health insurance. Their health insurance
   has a $200 deductible and provides 80/20 coverage. The insurance will pay 80% × ($1,200 –
   $200) = $800. Dana and David must pay a total of $650 ($3,000 – $2,750 + $1,200 – $800).
                                                 Chapter 11 | Social Security and Other Social Insurance   303




DISCUSSION QUESTIONS AND SOLUTIONS

        1. For purposes of Social Security and disability benefits, what is the meaning of
           substantial work in 2010?
           In 2010, earnings of $1,000 or more per month are considered substantial.
        2. When was Social Security legislation passed?
           August 14, 1935
        3. When was Social Security legislation passed to include a cost-of-living
           adjustment?
           1972
        4. How are Social Security benefits financed?
           From payroll taxes: 7.65% per employee and 7.65% per employer for each employee. Self-
           employed persons pay 15.3%.
        5. Is there a maximum payroll amount to which Social Security taxes apply?
           Yes; $106,800 for OASDI for 2009 and 2010. There is no payroll limit to which the 1.45%
           Medicare tax applies.
        6. In order to qualify for OASDI disability benefits, what definition of disability
           must be met?
           The inability to engage in any substantial gainful activity by reason of disability expected to
           last at least 12 months or result in death.
        7. Describe the major benefits under the Social Security program.
           There are six major categories of benefits administered by the Social Security
           Administration: (1) retirement benefits, (2) disability benefits, (3) family benefits, (4) survi-
           vors benefits, (5) Medicare, and (6) Supplemental Security Income (SSI) benefits.
        8. Identify and describe the benefits available to those covered under OASDI.
           The benefits available to those covered under OASDI are retirement benefits, family ben-
           efits, survivors benefits, and disability benefits. The retirement benefit is payable at full
           retirement age, with reduced benefits as early as age 62, to anyone who has obtained a
           minimum number of Social Security credits. The family benefit is provided to certain family
           members of workers eligible for retirement or disability benefits. Survivors benefits apply to
           certain members of the worker’s family if the worker earned sufficient Social Security credits.
           A special one-time payment of $255 may be made to the spouse or minor children upon the
           death of a covered worker. The disability benefit is payable at any age to workers who have
           sufficient credits under the Social Security system. Recipients must have a severe physical
           or mental impairment that is expected to either prevent them from performing substantial
           work for at least a year or result in death.
        9. How would a person who is entitled to Social Security benefits become ineligible
           for benefits?
           There are three different ways to become ineligible for benefits: (1) through the earnings
           limitation requirement for those age 62 until full retirement age; (2) through the maximum
           family benefit formula, or (3) failing to file an application and claim form with the Social
           Security Administration for benefits.
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                         10. What are the coverages that make up the Medicare program?
                               There are four parts to Medicare: Hospital Insurance (Part A), Medical Insurance (Part B),
                               Medicare Advantage (Part C), and Prescription Drug Coverage (Part D).
                         11. Define and explain the meaning of fully insured, currently insured, and disability
                             insured under the OASDI program.
                               Fully insured workers (40 quarters or 10 years of covered employment under Social Security)
                               are entitled to the benefits under the Social Security system, although some benefits, like
                               survivors benefits, are available to currently insured individuals. Currently insured workers
                               are those individuals that have at least 6 quarters of coverage out of the previous 13 quarters.
                               Disability insured allows disability benefits even though not fully or currently insured and is
                               based on age as follows: before age 24, must have 6 quarters of coverage in the last 12 quarters;
                               age 24–30, must be covered for half of the available quarters after age 21; age 31 or older, must
                               be fully insured and have 20 quarters of coverage in the last 40 quarters.
                         12. What are the requirements to be fully insured under OASDI?
                               To be fully insured, a worker must earn 40 quarters of coverage or one quarter for every year
                               starting at age 22 under the Social Security system. Since 1978, quarters of coverage have
                               been determined based on annual earnings whereby earning a designated amount of money,
                               regardless of when it was earned during the year, will credit the worker with a quarter of cov-
                               erage for that year. In 2010, the designated amount for a quarter of coverage is $1,120. Thus,
                               workers who earned at least $4,480 are credited with 4 quarters in 2010.
                         13. What Social Security benefits are available to the dependents of a deceased
                             worker who was only currently insured?
                               A child under 18 and a spouse with a child under 16 are eligible for 75% of the deceased
                               worker’s retirement benefit (PIA).
                         14. What Social Security benefits would a fully insured worker have that a currently
                             insured worker would not have?
                               A currently insured worker is not eligible for retirement benefits until acquiring fully insured
                               status.
                         15. What requirements must a person satisfy to receive Social Security (OASDI)
                             disability income benefits?
                               Meet a 5-month waiting period, be disability insured, and satisfy the definition of disability.
                         16. How is Social Security funded?
                               The sources of employee funding for the Social Security Trust Funds are as follows:
                               (1) OASI Trust Fund 5.30% (limited to the maximum taxable earnings); (2) DI Trust Fund
                               .90% (limited to the maximum taxable earnings); (3) HI Trust Fund 1.45% (no ceiling
                               on earnings taxed); (4) SMI Trust Fund 0% (funded by general federal tax revenues and
                               monthly premiums paid by enrollees). In addition, employers match employee funding.
                                         Chapter 11 | Social Security and Other Social Insurance   305


17. To qualify for Social Security OASDI benefits, how many credits does one need?
    How is a credit determined?
    To qualify for retirement benefits, a worker must earn 40 quarters of coverage or 1 quarter of
    coverage for every year starting the year following the year the worker attained age 21 under
    the Social Security system. To qualify for disability benefits, the requisite number of quarters
    depends on the worker’s age. (See the answer to disability insured in question 11 above.)
    To qualify for survivors benefits and the one-time death benefit, the deceased worker must
    have been currently insured (at least 6 quarters of coverage out of the previous 13 quarters).
    Since 1978, credits have been awarded based on quarters of coverage from annual earnings
    whereby earning a designated amount of money, regardless of when earned during the year,
    will credit the worker with a quarter of coverage for that year.
18. What percentage of income does Social Security typically replace for various
    wage earners?
    Low wage earners receive benefits of roughly 56% of preretirement income. However,
    medium wage earners receive only 41% of their preretirement income from Social Security
    benefits, whereas high wage earners receive only 34% of their preretirement income. Wage
    earners who earn more than the maximum Social Security wage base receive only 28% of
    their preretirement income.
19. How is OASDI insured status determined, and why is it important?
    As shown in the answers to questions 11, 12, and 17, an insured’s status is determined on
    the basis of the given worker’s annual earnings, which provide credits for quarters of cov-
    erage. Insured status is important because, if a worker is not fully, currently, or disability
    insured, that worker or the worker’s family members are not entitled to benefits. The Social
    Security system is based on provision of benefits to those who contributed to the system for
    a given period, depending on the specific benefit to be awarded.
20. How are monthly benefit payments under OASDI determined?
    Monthly benefit payments are based on the individual’s primary insurance amount (PIA),
    which is based on the individual’s averaged indexed monthly earnings (AIME).
21. What is normal retirement age for OASDI benefits for someone born in 1942?
    65 and 10 months
22. Is a recipient of Social Security benefits subject to purchasing power risk?
    No. Social Security benefits are adjusted for inflation.
23. What are the four benefits payable under the OASDI program?
    The four benefits payable under the OASDI program are (1) retirement benefits, (2) survi-
    vors benefits, (3) family benefits, and (4) disability benefits.
24. If a taxpayer’s income exceeds a specified base amount, as much as 50% or
    85% of Social Security retirement benefits must be included in gross income.
    Calculate the amount of the Social Security benefit that would be taxed at the
    50% level.
    Lesser of
    .50 × (Social Security benefits)
    or
    .50 × [modified adjusted gross income + .50 × (Social Security benefits) – first base amount]
306    Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition




      EXERCISES AND SOLUTIONS

                            1. Michael was 33 and had two dependent children, ages 4 and 6, who are cared for
                               by their mother when he died in the current year. He had accumulated 20 quar-
                               ters under Social Security at the time of his death. What are the benefits that his
                               survivors are entitled to under Social Security?
                                A death benefit of $255 is payable to the surviving spouse or children of the deceased
                                worker if he is fully or currently insured. The children’s benefit of 75% of PIA is payable
                                because Michael is fully insured. The mother of the children is entitled to a benefit of 75%
                                of PIA because the children are under age 16.
                            2. In 2010, James earned $5,000 from employment subject to Social Security
                               between January 1 and March 31. He was then unemployed for the remainder
                               of the year. How many quarters of coverage did he earn for Social Security for
                               2010?
                                For 2010, a worker receives 1 quarter credit for each $1,120 in annual earnings on which
                                Social Security taxes are paid up to a maximum of 4 quarters. It is irrelevant that he earned
                                the $5,000 all in the first quarter. He still earned 4 quarters for the year.
                            3. Charles, age 38, has just died. He has been credited with the last 30 consecutive
                               quarters of Social Security coverage since he left school. He did not work before
                               leaving school. Which of the following persons are eligible to receive Social
                               Security survivor benefits as a result of Charles’s death?
                                ■■   Bill, Charles’s 16-year-old son.
                                ■■   Dawn, Charles’s 18-year-old daughter.
                                ■■   Margaret, Charles’s 38-year-old widow.
                                ■■   Betty, Charles’s 60-year-old dependent mother.
                                Dawn is age 18 and is not entitled to a child's benefit; Margaret does not have a child under
                                16, and she is too young for a widowed spouse's benefit; and Betty is not eligible because she
                                under age 62. Only Bill is eligible.
                            4. Under Social Security (OASDI), what benefits are available to the survivors of a
                               deceased who was currently insured?
                                A $255 death benefit is payable to the insured’s spouse and 75% of the worker’s PIA is avail-
                                able to a child under 18 or to a surviving spouse with a dependent child under the age of 16.
                            5. Which of the following persons are eligible to receive immediate survivor income
                               benefits based on a deceased worker’s primary insurance amount (PIA), under
                               OASDI (Social Security)?
                                ■■   A surviving spouse caring for an under 16-year-old child.
                                ■■   Unmarried children under age 18 who are dependents.
                                ■■   Unmarried disabled children who became disabled before age 22.
                                ■■   Any surviving divorced spouse over 50 with no children who was married to
                                     decedent for over 10 years and who is disabled.
                                All persons are eligible.
                                        Chapter 11 | Social Security and Other Social Insurance   307



6. How is a worker’s insured status determined under Social Security?
   By the number of quarters of coverage earned—to achieve currently insured status under
   Social Security, a worker must have at least 6 quarters of coverage out of 13 calendar quar-
   ters prior to retirement, disability, or death. Any worker with 40 covered quarters of cover-
   age is forever fully insured.
7. Philip began his professional corporation single practitioner CPA firm 39 years
   ago at age 27. He worked profitably as a sole practitioner for the full 38 years
   and is now age 63 and 6 months. He retired December 31, 2009. On January 1,
   2010, he sold his practice for $400,000 to be received in four equal annual
   installments beginning on January 1, 2010. Is Philip eligible for Social Security
   retirement benefits during 2010? Why or why not?
   Yes, he is eligible because he is of retirement age, and fully insured. The installment sale
   proceeds are not earned income and, therefore, do not affect his ability to receive his Social
   Security benefits.
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      PROBLEMS AND SOLUTIONS

                            1. Larry was married at the following ages and to the following wives. Larry is fully
                               insured and is 62 and married to Dawn.

                                                                           Larry’s Age     Current
                                                 Wife     Current Age      at Marriage   Marital Status   Length of Marriage
                                         1      Alice          62               20           Single       10 years, 1 month
                                         2      Betty          63               31           Single       10 years, 1 month
                                         3      Claire         64               42           Single       9 years
                                         4      Dawn           65               53          Married       9 years

                                Who, among the wives, may be eligible to receive Social Security retirement ben-
                                efits based on Larry’s earnings if Larry is retired or not retired?
                                Any divorced spouse age 62 and married to Larry for 10 years or longer (and not remarried
                                before age 60) and his current wife, Dawn, if he is retired. His current spouse cannot collect
                                based on Larry's earnings if he is not retired. Dawn may be eligible to collect benefits based
                                on her own work history, without regard to whether or not Larry is retired.
                                If Larry is retired: Alice, Betty, and Dawn.
                                If Larry is not retired: Alice and Betty.
                            2. Rob earned $62,000 last year. Calculate his FICA contribution for the year.
                               How much did his employer pay toward FICA?
                                Rob paid $3,844 ($62,000 × 6.2%) to FICA and $899 ($62,000 × 1.45%) to Medicare, and
                                his employer matched the payments of $3,844 and $899, respectively.
                            3. Last year Michelle, filing single, received $10,400 in Social Security benefits.
                               For the entire year, she had adjusted gross income of $28,000. How much, if
                               any, of her Social Security benefit is taxable?
                                First, it is necessary to determine her modified adjusted gross income. Modified adjusted
                                gross income is the sum of adjusted gross income, nontaxable interest, and foreign-earned
                                income plus 50% of Social Security benefits received. For Michelle, the equation is as fol-
                                lows: $28,000 + ($10,400 × .50) = $33,200 of modified adjusted gross income. Because
                                Michelle’s modified adjusted gross income is between the two base amounts for a single indi-
                                vidual of $25,000 and $34,000, we can use the following formula to determine her taxable
                                amount. The tax will be the lesser of 50% of her Social Security Benefits or 50% (modified
                                adjusted gross income—base amount of $25,000). Based on the formula, Michelle will be
                                subject to tax on $4,100 of her Social Security benefit.
                                (50% × $10,400) = $5,200
                                50% ($33,200 – $25,000) = $4,100 < LESSER
                            4. Mike is 66 years old in 2010. He has a full-time job working as a masseur. This
                               year, he anticipates earning $22,000 from his job. How much, in dollars, will
                               Mike’s Social Security benefits be reduced?
                                None, because he has reached normal retirement age and is no longer subject to the
                                earnings limitation.
                                       Chapter 11 | Social Security and Other Social Insurance   309


5. A married couple, who file jointly, with adjusted gross income of $38,000, no
   tax-exempt interest, and $11,000 of Social Security benefits must include how
   much of their Social Security benefits in gross income?
   The lesser of the following:
   .50 ($11,000) = $5,500 or
   .50 [$38,000 + .50($11,000) – $32,000] = .50($11,500) = $5,750
   They will include $5,500 in gross income. If the couple’s adjusted gross income were $15,000
   and their Social Security benefits totaled $5,000, none of the benefits would have been tax-
   able because .50 [$15,000 + .50 ($5,000) – $32,000] is negative.
                                                       Chapter 12 | Introduction to Investment Planning   327




DISCUSSION QUESTIONS AND SOLUTIONS

        1. How does investment planning fit into the overall framework of financial
           planning?
           The professional financial planner’s purpose is to assist clients in achieving their financial
           goals and objectives while helping them reduce certain personal and financial risks.
           Investment planning and portfolio evaluation are key elements in achieving financial plan-
           ning goals.
        2. What investment goals are common to most investors, and how are these goals
           achieved?
           ■ Purchasing a home
           ■ Funding for a child’s college education
           ■ Retirement planning
           In each of these cases, accomplishing the specific financial planning goal requires that the
           individual save and invest funds for a certain period. However, because the time horizon of
           each goal is different, the ability to tolerate fluctuation in the value of the invested assets is
           also different. Obviously, there is more tolerance for fluctuation when planning for retire-
           ment than when saving for a down payment on a home.
        3. What are two methods of increasing the savings rate for an investor?
           Reducing expenditures, especially discretionary expenditures, is an excellent way to increase
           savings for investment. Another method to increase savings over time is to allocate future
           raises to savings.
        4. How are systematic risk and unsystematic risk different?
           Systematic risks are risks impacted by broad macroeconomic factors that influence all securi-
           ties. These risks include market risk, interest rate risk, purchasing power risk, foreign currency
           risk, and reinvestment risk. Diversification cannot eliminate systematic risk because these
           factors affect all securities. Unsystematic risks are those risks that are unique to a single
           company, industry, or country. These risks include default risk, business risk, financial risk and
           country risk. Unlike systematic risk, these risks can be eliminated through diversification.
        5. What are lending investments and ownership investments, and how do they
           differ?
           Savings accounts and bonds are both examples of lending investments. When cash is depos-
           ited into a savings account, the owner has, in effect, loaned money to the bank. The bank,
           which will lend the money to a consumer in the form of a mortgage or other debt instru-
           ment, will in return pay the owner interest. On the other hand, ownership investments take
           the form of common or preferred stock. Common stockholders accept the risks inherent in
           owning a company. Bondholders have a right to be repaid funds that were loaned; however,
           common stockholders have invested in the potential future profitability of the business.
           There is more risk for common stockholders than for bondholders; in the event of bankrupt-
           cy, bondholders are paid before stockholders. Investors require higher returns for common
           stock to compensate for the increased risks associated with owning equity securities. In addi-
           tion, equities tend to have more price volatility than bonds.
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                          6. What are the benefits of owning real estate in an investment portfolio?
                               ■ Cash flow—generally, real estate investments produce a generous amount of cash flow
                                 through rents.
                               ■ Depreciation deductions—many real estate investments have deductions for depreciation
                                 that can offset taxable income from the investment and from other sources. In many
                                 cases, real estate investments can generate positive cash flow without having taxable
                                 income. In some cases, taxable losses are generated along with positive cash flow. These
                                 taxable losses are due to the deductibility of depreciation.
                               ■ Low correlation to other asset classes—it is often advantageous to add asset classes that
                                 have low correlation to equities and fixed-income securities to portfolios to reduce the
                                 overall risk of the portfolio. Real estate has a low correlation of returns to common stock,
                                 preferred stock, and bonds.
                          7. What are the two types of derivatives discussed in the chapter?
                               Options and futures. Options are derivatives that give the holder or buyer the right to pur-
                               chase or sell an asset. A futures contract obligates the purchase or sale of an asset.
                          8. What are the differences in the obligations and rights with regard to option con-
                             tracts and futures contracts?
                               Call options give the holder the right to purchase the underlying security, generally stock,
                               at a specified price within a specified period. Put options give the holder the right to sell
                               the underlying security, generally stock, at a specified price within a specified period.
                               Unlike options, which give the holder a right to purchase or sell a specific security, a futures
                               contract is an agreement to do something in the future. Generally, purchasing (selling) a
                               futures contract obligates the buyer (seller) to take delivery (make delivery) of a specific
                               commodity, at a specific price, and at a specific time in the future.
                          9. What is the difference between direct investing and indirect investing?
                               Investing in bonds or stocks can be accomplished by purchasing the actual securities directly
                               from the corporation or entity issuing the stocks or bonds, or by investing indirectly through
                               mutual funds, unit investment trusts, or exchange-traded funds that purchase their securities
                               directly from the issuing corporations or authorities. Direct investing occurs when investors
                               purchase the actual securities. Indirect investing is a process of investing in securities
                               through mutual funds, unit investment trusts, or exchange-traded funds that invest directly.
                         10. Describe the basic theoretical assumption of behavioral finance.
                               Behavioral finance is a branch of personal finance that proposes psychology-based theories
                               to explain investor behavior and stock market anomalies. Behavioral finance argues that
                               investors are not nearly as rational as believed by traditional finance theorists. Critics of
                               behavioral finance contend that the theory is more a collection of market anomalies than
                               irrational investor behavior and that these anomalies eventually will be priced out of the
                               market.
                         11. How are the two common measures of risk—beta and standard deviation—
                             different?
                               Beta is a measure of systematic risk and provides an indication of the volatility of a portfolio
                               compared to the market. Because beta measures systematic risk, it is a good measure of risk
                               for diversified portfolios. However, when the diversification of the portfolio is low and the
                               portfolio has a substantial amount of unsystematic risk, beta does not capture all of the vola-
                               tility within the portfolio. Unlike beta, standard deviation measures both total volatility of
                               the portfolio and total risk (i.e., systematic and unsystematic risk) of the portfolio. Standard
                               deviation is a statistical measure of how far actual returns deviate from the mean return.
                                              Chapter 12 | Introduction to Investment Planning   329


12. What are the differences between the arithmetic mean and the geometric mean?
    The arithmetic mean is a measure of investment return that is the result of averaging
    periodic returns. The geometric mean is a method of calculating the internal rate of
    return based on periodic rates of return. The geometric mean takes into consideration the
    compounding of investment returns over time, whereas the arithmetic mean does not. The
    arithmetic mean is not as useful for investment purposes as the geometric mean, and the
    difference between the two measures will be greater as the returns are more volatile.
13. How are the nominal rate of return and real rate of return different?
    The nominal return is the stated return from the investment. The real rate of return is the
    nominal return adjusted for inflation, using the following formula:

                          (1 + nominal return) 
                          (1 + inflation rate) − 1 × 100 = real rate of return
                                                  

14. What is the efficient frontier, and what is its role in modern portfolio theory?
    Modern portfolio theory (MPT) describes the diversification process. Markowitz found that
    by combining different asset classes and varying the weightings of each asset class, he could
    create portfolios that had higher returns with less portfolio volatility (risk). He called the
    portfolios that had the highest expected return for the given level of risk efficient portfo-
    lios. By combining these efficient portfolios, he created the efficient frontier. The efficient
    frontier consists of portfolios with the highest expected return for a given level of risk.
    Markowitz came up with the following three rules for choosing efficient portfolios.
    ■ For any two portfolios with the same expected return, choose the one with the lowest
      risk.
    ■ For any two portfolios with the same risk, choose the one with the highest expected
      return.
    ■ Choose any portfolio that has a higher expected return and lower risk.
    Portfolios do not exist above the efficient frontier because the efficient frontier consists of
    the most efficient portfolios (portfolios of assets with the highest expected return for a given
    level of risk). Today, the efficient frontier provides the framework for asset allocation.
15. What type of information is conveyed by the correlation coefficient?
    The correlation coefficient, generally denoted by the symbol R, is a statistical measure gen-
    erated from a regression analysis that provides insight into the relationship between two
    securities, two portfolios, or two indexes. The correlation coefficient indicates the direction
    of the relationship between the two indexes or securities and the strength between the two
    items. The correlation coefficient ranges between +1.0 and –1.0. At +1.0, there is perfect
    positive correlation between two items. In other words, the two items will move together
    over time. At –1.0, there is perfect negative correlation between two items. In other words,
    the two items will move in opposite directions over time. At a correlation of zero, there is
    no relationship between the two items, and they will move independent of each other. The
    correlation coefficient is the key to the concept of asset allocation. When the correlation
    coefficient between two asset classes is less than 1.0, combining the asset classes will reduce
    the overall risk of the investment portfolio. The lower the correlation, the lower the stan-
    dard deviation of the combined portfolio and, therefore, the lower the risk.
16. What is the efficient market hypothesis (EMH)?
    The efficient market hypothesis (EMH) is a theory that suggests that the market prices
    securities fairly and efficiently, and investors are unable to outperform the market on a con-
    sistent basis without accepting additional risk. In fact, the EMH states that securities prices
    reflect all historical information. Therefore, analyzing historical information using techni-
330   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                               cal or fundamental analysis will not provide an advantage. The only information that will
                               affect the price of a security will be new, unknown information. As new information affect-
                               ing a security is released, the price of the security will increase if the information is positive
                               and decrease if the information is negative. Because new information is by its very nature
                               unknown, it is random, or unpredictable. Thus, security prices should follow a random walk,
                               or an unpredictable pattern. The EMH is often evaluated under three forms: the weak, semi-
                               strong, and strong forms. Each of these forms differs as to the level of information that is
                               thought to be efficiently incorporated into a security’s price.
                         17. What makes timing the market such a difficult process?
                               Market timing is a strategy whereby investors attempt to be fully invested in the market
                               during periods of upward movements in the market and to be out of the market when it is
                               declining. Knowing when to buy and when to sell is the inherent difficulty with this type of
                               strategy. In addition, the transaction costs incurred while exiting and entering the market
                               may become quite large. Although there are many ways to time the market, the majority
                               of academic studies indicate that it is not possible to successfully outperform the market by
                               attempting to time its rise and fall.
                         18. What are anomalies, and how do they provide a counterargument to the validity
                             of the EMH?
                               Anomalies are occurrences in the stock market that are not supported by the concept of an
                               efficient market. For example, if a method of trading results in superior returns, the trading
                               method implies that the market is not perfectly efficient.
                         19. What is indexing, and how is it used?
                               The market is generally represented by an index, or benchmark, such as Standard & Poor’s
                               500 Index. These indexes provide investors with a benchmark of the performance of differ-
                               ent segments of the market. Indexing is the concept of investing in the same securities and
                               in the same proportions represented by an index. For instance, an investor might purchase
                               the same securities that make up the S&P 500. However, purchasing 500 stocks and pur-
                               chasing them in the correct proportions requires a substantial investment. Therefore, inves-
                               tors will often invest in index mutual funds. These funds provide an inexpensive method
                               for investors to receive the performance of an index without the hassle of mimicking the
                               structure of the index.
                               Indexing has actually been an effective investment strategy. Historical return results indicate
                               that the majority of active managers do not produce returns in excess of returns earned by
                               indexes or index mutual funds.
                         20. What is the difference between active and passive portfolio management?
                               Active and passive investment strategies are commonly used approaches to investing. Active
                               management is an attempt to outperform the returns that are available to those investors
                               using a passive approach. It is through the process of finding undervalued or mispriced secu-
                               rities that active managers attempt to earn these higher returns. Active management gener-
                               ally requires more research and support than passive strategies. Therefore, the expenses asso-
                               ciated with active management are generally higher than for passively managed approaches.
                               A passive approach to investment management does not attempt to find undervalued securi-
                               ties. Instead, this approach assumes, as does the EMH, that investors will be unable to con-
                               sistently outperform the market over the long term. As a result, managers will not employ
                               active strategies and will generally hold a well-diversified portfolio, often based on an asset
                               allocation. Over time, the portfolio may have to be rebalanced because of different rates of
                               return for different asset classes within the portfolio. However, a passive approach will have
                               lower costs, for both transaction fees and management fees. One method of passive investing
                               is the use of index funds.
                                                     Chapter 12 | Introduction to Investment Planning   331




EXERCISES AND SOLUTIONS

        1. List five systematic risks and explain each.
           ■ Market risk—the tendency for securities to move with the market
           ■ Interest rate risk—the risk that changes in interest rates will affect the value of securities
           ■ Purchasing power risk—the risk that inflation will erode the real value of the investor’s
             assets
           ■ Foreign currency risk—the risk that a change in the relationship between the value of the
             dollar and the value of the foreign currency will occur during the period of investment
           ■ Reinvestment risk—the risk that earnings distributed from current investments cannot be
             reinvested to yield a rate of return equal to the expected yield of the current investments
        2. List five unsystematic risks and explain each.
           ■ Business risk—risk associated with uncertainty of operating income
           ■ Financial risk—financial leverage of a firm based on its capital structure
           ■ Default risk—the risk that a business will be unable to service its debt
           ■ Country (regulation) risk—the risk that changes in the law will have an adverse effect on
             an investment
           ■ Tax risk—the risk that taxation of investment gains or losses will adversely affect a inves-
             tor's investment return
        3. Compare and contrast common and preferred stock.
           Ownership investments take the form of common or preferred stock. Common stockholders
           accept the risks inherent in owning a company. If the company is successful, the value of the
           common stock will increase. If the company is unsuccessful, the value of the common stock
           will decline. Investors of common stock are rewarded for accepting risk in two ways. The
           first is through appreciation in the value of the stock. The second is from earnings that are
           paid to the shareholders in the form of dividends. A dividend is a payment made by the cor-
           poration to the shareholders as a return of the profits of the corporation. Preferred stock has
           characteristics of both bonds and common stock. Like bonds, preferred stock generally pays
           a fixed amount, called a preferred stock dividend, which is determined as a percentage of the
           par value of the preferred stock. Preferred stock is subject to many of the same risks as bonds.
           However, preferred stock does not have a finite maturity date. Instead, like common stock,
           preferred stock continues for as long as the company continues or until it is retired.
        4. Hewkard stock has recently had a market correction. If Bill likes the long-term
           prospects of the stock, what option position(s) might he choose and why?
           The best choice to participate in the anticipated long-term growth of the stock is for Bill
           to purchase a call option. Another alternative is for Bill to write a put option on the stock.
           If the put option expires out-of-the money, Bill will retain the premium. If the put option
           is in-the-money, Bill will be obligated to purchase the stock. However, his loss with be par-
           tially mitigated by the premium he received for selling the put.
332   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                          5. Harry bought XYZ Company 15 years ago. The stock has greatly appreciated
                             recently, and Harry is concerned about a correction. List two alternatives that he
                             could implement to minimize losses in the event of a correction.
                               ■ Sell a call option—provides additional income and allows the current position to be
                                 maintained.
                               ■ Buy a put option—establishes a floor in the event that the stock declines.
                          6. The efficient market hypothesis is often evaluated under three forms. List them
                             and explain how each incorporates information efficiently into a security’s price.
                               The weak form asserts that securities' prices reflect information related to the security’s trad-
                               ing data, including price information, volume information, and short interest information.
                               Under this form, analyzing trends in the price of securities, such as in technical analysis, is
                               insignificant because the price of the security already reflects this information.
                               The semistrong form asserts that securities' prices not only reflect a security’s trading data
                               but also all publicly available information related to the security, industry, and economy.
                               This public information includes analysis of the company’s products, management, fixed
                               and variable cost structure, earnings and cash flow, and analysis of the industry in which the
                               company is included. This type of analysis of publicly available information is referred to
                               as fundamental analysis and is commonly used in determining the intrinsic value of a secu-
                               rity. For those who believe in the semistrong form, there is no benefit to using fundamental
                               analysis.
                               The strong form goes even further than the other forms. It asserts that all public and private
                               information is included in the price of a security. Therefore, even inside information will not
                               allow investors to outperform the market on a consistent basis.
                                                     Chapter 12 | Introduction to Investment Planning   333




PROBLEMS AND SOLUTIONS

        1. Michael invests $10,000 in Bonsai, Inc., which is based in Japan. The conver-
           sion rate at the time of the investment is 100 yen to $1. Michael sells his inter-
           est 6 months later for 1,750,000 yen. However, the exchange rate now is 125
           yen to $1. What is Michael’s return on the investment (before yen to dollars),
           return due to exchange rate risk, and net result on the original investment?
           Gain on investment = 1,750,000 yen – 1,000,000 yen = 750,000 yen or 75%
           Loss due to exchange rate risk = (100 yen/$ ÷ 125 yen/$) – 1 = 20%
           Net result on original investment = $14,000 – $10,000 = $4,000 or 40%
        2. Kyle purchases one lot (100 shares) of Superstock for $6,500. One year later,
           he sells the lot when the stock is trading for $79 per share. Superstock does not
           pay dividends. What is Kyle’s holding period return?

                                                                               n
                       ending value of investment − beginning value of investment +/ − cash flows
               HPR =
                                             beginning value of investment

                                                   $79 − $65
                                           HPR =             = 21.54%
                                                     $65

        3. Use the chart to answer the following question:

                                                Year    Return
                                                 1       10%
                                                 2       –5%
                                                 3       18%
                                                 4        6%
                                                 5        1%

           Calculate the arithmetic mean for the 5-year period.

                  10% − 5% + 18% + 6% + 1%
           AM =                            = 6%
                              5

           Calculate the geometric mean for the 5-year period.
           Assume $100 is initially invested.
           PV = –$100
           FV = 100(1.10)(0.95)(1.18)(1.06)(1.01) = 132.02
           n   =5
           Solve for i = 5.71%
334   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                          4. Eric had the following returns on his portfolio for the last 5 years: 10%, 8%,
                             13%, 15%, and 11%. What is the arithmetic mean for Eric’s portfolio?

                                                                  10% + 8% + 13% + 15% + 11%
                                                          AM =                               = 11.40%
                                                                               5

                          5. Janet has a portfolio that has a correlation with the market of 0.8 and a stan-
                             dard deviation of 20%. Determine how much unsystematic risk is within Janet’s
                             portfolio.
                               R = 0.8
                               R 2 = 0.64 (systematic risk = 64%)

                               Unsystematic risk = 1.00 – 0.64 = 0.36 or 36%
                          6. Tyler had the following returns on his high-risk portfolio over a 5-year period:
                             35%, −10%, 25%, 65%, and −5%. What is the geometric mean for Tyler’s
                             portfolio?
                               Assume Tyler invests $100.
                               PV = –$100
                               FV = 100(1.35)(.90)(1.25)(1.65)(0.95) = $238.06
                               n    =5
                               Solve for i = 18.94%
                          7. Sandra expects to earn an after-tax rate of return over a long period of time of
                             10%. If inflation is expected to continue at 3%, what is Sandra’s real rate of
                             return?
                                                                  (1 + R n ) 
                                                   Real return =            − 1 × 100
                                                                  (1 + i)      

                                                                  (1 + .10) 
                                                   Real return =           − 1 × 100 = 6.7961% or 6.8%
                                                                  (1 + .03) 

                          8. If portfolio A has a coefficient of determination of 0.64 when compared to the
                             S&P 500 Index, what portion of the risk of the portfolio is considered unsys-
                             tematic risk?
                               R 2 = 0.64 (systematic risk = 64%)

                               Unsystematic risk = 1.00 – 0.64 = 0.36 or 36%
                          9. If Portfolio B has a correlation with the market of 0.70, what portion of the risk
                             of the portfolio can be eliminated through diversification?
                               R = 0.70
                               R 2 = 0.49 (systematic risk = 49%)


                               Unsystematic risk = 1.00 − 0.49 = 0.51 or 51%
350    Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition




      DISCUSSION QUESTIONS AND SOLUTIONS
                           1. What are the objectives of federal income tax law?
                                There are several objectives of federal income tax law. These objectives can be classified as
                                revenue-raising, economic, and/or social in nature.
                                The revenue-raising objective is the most important of these. The primary goal of taxation is
                                to provide the resources necessary to fund governmental expenditures.
                                The federal income tax system is also used to address certain economic goals. The govern-
                                ment uses taxation to achieve the goals of economic growth and full employment. Social
                                objectives are also accomplished through effective income tax legislation. The Internal
                                Revenue Code (IRC) contains many economic incentives designed to encourage certain
                                social behavior.
                           2. What is the alternative minimum tax?
                                The alternative minimum tax (AMT) is a separate tax system that parallels the regular tax
                                system. The AMT system was designed to ensure that individuals with large deductions and
                                other tax benefits pay at least a minimum amount of tax.
                           3. What is a capital asset?
                                All assets are capital assets except for the following:
                                ■ Accounts or notes receivable arising in the ordinary course of a trade or business
                                ■ Copyrights or creative works held by the creator
                                ■ Inventory or property held for sale to customers in the ordinary course of the taxpayer’s
                                  trade or business
                                ■ Depreciable real or personal property used in a trade or business
                                ■ A US government publication held by a taxpayer who received it other than by purchase
                           4. What is the formula for determining a client’s income tax liability?
                                Computing an individual’s income tax liability can be very complicated. The tax liability
                                itself is a product of the taxpayer’s taxable income, which is summarized in the following
                                formula:

                                            Total income (from whatever source derived)               $xx,xxx
                                                Less: exclusions from gross income                      (x,xxx)
                                            Gross income                                              $xx,xxx
                                                Less: deductions for adjusted gross income              (x,xxx)
                                            Adjusted gross income (AGI)                               $xx,xxx
                                                Less: the larger of standard deduction or itemized      (x,xxx)
                                                deductions
                                                Less: personal and dependency exemptions                (x,xxx)
                                            Taxable income                                            $xx,xxx



                           5. What are some of the types of government rulings issued as guidance to
                              taxpayers?
                                Guidance is often given by way of Letter Rulings, Determination Letters, Revenue Rulings,
                                Private Letter Rules, Revenue Procedures, and Technical Advice Memoranda.
                                            Chapter 13 | Individual Income Tax and Tax Planning   351


   ■ A Letter Ruling is essentially a statement by the IRS of the way it will treat a prospec-
     tive or contemplated transaction for tax purposes and is not to be relied on by other
     taxpayers.
   ■ A Determination Letter is a written statement issued by a District Director of the IRS.
     The letter applies the principals and precedents announced by the National Office to a
     given set of facts.
   ■ Revenue Rulings are issued by the National Office of the IRS. They provide an official
     interpretation of how the law should be applied to a specific set of facts and may be relied
     on as precedent.
   ■ Private Letter Rulings are statements issued for a fee upon a taxpayer's request that
     describe how the IRS will treat proposed transactions for tax purposes.
   ■ Revenue Procedures are statements reflecting the internal management practices of the
     IRS that affect the rights and duties of taxpayers.
   ■ Technical Advice Memoranda give advice or guidance in memorandum form and are
     furnished by the National Office of the IRS. An IRS agent typically requests the memo-
     randum during an audit. Technical advice helps IRS personnel close cases and maintain
     consistent holdings throughout the IRS.
6. When taxpayers violate the tax laws, what civil penalties might they expect to
   incur?
   Various civil penalties are imposed on taxpayers and return preparers who violate the tax
   law. Included in the civil penalties are failure-to-file penalties, failure-to-pay-tax penalties,
   accuracy-related penalties, and fraud penalties.
   The failure-to-file penalty was enacted to ensure the timely filing of tax returns. The failure-
   to-pay-tax penalty is imposed on taxpayers who, without reasonable cause, fail to pay the tax
   shown on a return. The accuracy-related penalty is a penalty of 20% of the portion of the
   tax underpayment attributable to negligence, substantial understatement of tax, or substan-
   tial valuation misstatement. The fraud penalty is a penalty of 75% of the portion of the tax
   underpayment attributable to the fraud.
7. What payroll taxes did the Federal Insurance Contributions Act and the Federal
   Unemployment Tax Act create?
   The Federal Insurance Contributions Act (FICA) created several different programs
   designed to prevent people from becoming poverty stricken. The two most important and
   well-recognized programs created by FICA are Old Age, Survivors, and Disability Insurance
   (OASDI) and the Hospital Insurance (HI) program, better known as Medicare Part A.
   The Federal Unemployment Tax Act (FUTA) provides for payments of unemployment com-
   pensation to workers who have lost their jobs. Most employers pay both a federal and state
   unemployment tax. The employee is not responsible for paying unemployment tax.
8. What tax-advantaged investment options are available to taxpayers?
   ■ Investment in tax-exempt securities
   ■ Tax shelters
   ■ Acceleration of deductions
   ■ Deferral of tax gains
   ■ Exemption opportunities
352    Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition




      EXERCISES and SolutionS
                           1. Joe, a self-employed individual, earns $150,000 in self-employment income.
                              How much self-employment tax will Joe owe for 2009? For 2010?
                                Joe will be required to pay $17,260,43 in both 2009 and 2010, calculated as follows:

                                                                                                    2009             2010
                                                   Net earnings from self-employment              $150,000         $150,000
                                                      Less: 7.65% of net earnings                   (11,475)         (11,475)
                                                   Amount subject to SE tax                       $138,525         $138,525

                                                   Social Security portion 2009
                                                   (12.4% × $106,800)                             $13,243.20
                                                   Social Security portion 2010
                                                   (12.4% × $106,800)                                              $13,243.20
                                                   Medicare portion
                                                   (2.9% × $138,525)                                4,017.23         4,017.23

                                                   Total self-employment taxes                    $17,260.43       $17,260.43

                           2. Kay sold the following investments during the current year:


                                       Property           Date Sold*          Date Acquired*         Sales Price       Adjusted Basis
                                       ABC stock          2/3/CY              1/2/PY                 $3,300            $1,300
                                       Bond               2/5/CY              2/5/PY                 $1,200            $1,400
                                       Land               4/5/CY              5/4/PY                 $4,300            $3,400
                                       * CY = current year; PY = prior year


                                What is the amount of net long-term gain and net short-term gain on the sale of
                                the investments?
                                The net long-term gain is $2,000. The sale of the ABC stock results in a long-term gain
                                because the stock was held more than one year. The gain of $2,000 is calculated as the dif-
                                ference between the sales price of $3,300 and the cost basis of $1,300.
                                The net short-term gain is $700. The sale of the bond and land are both short term because
                                neither was held for more than a year. The gain on the sale of the land ($900) is reduced by
                                the loss on the sale of the bond ($200) to arrive at the net short-term gain.
                           3. Cindy sold 300 shares of XYZ stock for $5,200. She had paid $3,000 for the
                              stock. Commissions of $300 on the sale and $180 on the purchase were paid.
                                What is Cindy’s amount realized and her gain realized, respectively, on this sale?
                                The amount realized is $4,900, the sales price of $5,200 less commissions of $300 on the
                                sale. The gain realized is $1,720, calculated as follows:

                                         Amount realized ($5,200 – $300)               $4,900
                                         Adjusted basis ($3,000 + $180)                 (3,180)
                                         Gain                                          $1,720
                                          Chapter 13 | Individual Income Tax and Tax Planning   353


4. Don incurred $28,000 of medical expenses in the current year. His insurance
   company reimbursed him $6,000. Assuming his AGI is $100,000, what is the
   amount of medical expense deduction Don can claim for the year?
   Don can deduct medical expenses of $14,500, calculated as follows:

          Medical expenses incurred                $28,000
          Insurance reimbursement                      (6,000)
          Unreimbursed medical expenses            $22,000
          Less: 7.5% of AGI                            (7,500)
          Medical expense deduction                $14,500


5. The Durrs are a married couple with two school-age children they fully support.
   Use the following information about their 2010 finances to answer the following
   question.

                 Gross income                $91,350
                 Deductions for AGI           $6,000
                 Itemized deductions          $4,800


   Assuming the Durrs file a joint income tax return, what is their taxable income
   for 2010?
   Their taxable income is $59,350:

                                            2010
     Gross income                          $91,350
     Deductions for AGI                      (6,000)
     Adjusted gross income                  85,350
     Standard deduction (greater than
     itemized deductions)                  (11,400)
     Personal exemptions                    (14,600) (3,650 × 4)
     Taxable income                        $59,350


6. Susan, a single taxpayer, sold her home because she has a new job in another
   city. On the sale date, she had owned the home and used it as a personal resi-
   dence for 18 months. What is the maximum gain that Susan can exclude on the
   sale of the residence?
   Susan did not meet the two-year ownership and use tests required to take full advantage of
   the $250,000 gain exclusion. However, Susan sold her home due to a job change and there-
   fore is entitled to a partial exclusion.
   The maximum gain Susan can exclude is $187,500 ($250,000 × 18 ÷ 24).
7. During the current year, Scott had long-term capital losses of $2,000 and short-
   term capital losses of $1,500. If this is the first year he has experienced capital
   gains or losses, what amount of these losses may Scott deduct this year?
   Scott can deduct a capital loss of $3,000 for the current year. Note that short-term capital
   losses are used first. Therefore, Scott will have a long-term capital loss carryforward of $500.
354   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                          8. Pablo, a single individual, purchased a new personal residence for $375,000.
                             Pablo sold the property 12 months later for $550,000 so he could take a new job
                             that involved a promotion. How much gain must Pablo recognize?
                               Pablo did not meet the two-year ownership and use tests required to take full advantage of
                               the $250,000 gain exclusion. However, he sold the home due to a job change and therefore
                               is entitled to a partial exclusion.
                               The maximum gain Pablo can exclude is $125,000 ($250,000 × 12 ÷ 24). Therefore, he
                               must recognize gain of $50,000. ($550,000 sales price – $375,000 basis – $125,000 gain
                               excluded.)
                          9. David exchanged an apartment complex that he had owned for 8 years for farm-
                             land. The farmland was worth $1,050,000, and David’s basis in the apartment
                             complex was $475,000. David received $100,000 cash in the transaction. How
                             much is David’s gain realized and gain recognized as a result of this exchange?
                               David has a realized gain of $675,000 and a recognized gain of $100,000.

                                                Fair market value of farm land received                      $1,050,000
                                                Cash received                                                  100,000
                                                Amount realized                                              $1,150,000
                                                Less: basis of apartment                                       (475,000)
                                                Gain realized                                                 $675,000
                                                Gain recognized (to the extent of boot received)              $100,000


                         10. Doug and Susan, ages 45 and 40, are married and file a joint return for 2010.
                             The following pertains to their return for the year:

                                                             AGI                           $31,600
                                                             Itemized deductions           $13,000
                                                             Personal exemptions           2 (no children)


                               What are their taxable income and tax liability for 2010?

                                                                                        2010
                                                   Adjusted gross income               $31,600
                                                   Itemized deductions                 (13,000)
                                                   Personal exemptions                  (7,300)   ($3,650 × 2)
                                                   Taxable income                      $11,300
                                                   Tax on $11,300 @ 10%                $1,130
                                                   Total tax due                       $1,130
                                               Chapter 13 | Individual Income Tax and Tax Planning   355


11. Joe is a single taxpayer in the 35% tax bracket. During the current year, he sold
    the following assets:

                                   Investment                      Gain
                                   ABC company stock               $4,500
                                   XYZ company stock               $1,000
                                   Baseball card collection        $2,000
                                   Corporate bonds                 $6,000
                                   Antiques                        $8,000


    All of the assets were held longer than one year. How much capital gains tax will
    Joe have to pay as a result of the sales?
    The baseball card collection and antiques are collectibles, subject to the 28% rate.
    Therefore. the total capital gains tax is $4,525 [($4,500 + $1,000 + $6,000) × 15% +
    ($2,000 + $8,000) × 28%].
12. Susan filed her tax return 70 days after the due date. She remitted a check for
    $8,000 that represented the balance of the tax due. Calculate her failure-to-file
    and failure-to-pay penalties.

         Failure-to-pay ($8,000 × .5% × 3 months)                    $120 Failure-to-pay penalty
         Failure-to-file ($8,000 × 5% × 3 months)        $1,200
         Less: failure-to-pay penalty                       (120) $1,080 Failure-to-file penalty
         Total penalty                                             $1,200


13. Jim is in the 33% marginal income tax rate, and he would like to invest in State
    of Louisiana bonds. Assuming that similar taxable investments yield 12%, how
    much must Jim earn to make this a worthwhile investment?
    Jim must earn a rate of return on the State of Louisiana bonds of at least 8.04% [12% × (1 –
    33%)] to make this a worthwhile investment.
14. Allison is age 12 and has the following income:

                                  Investment income                 $1,800
                                  Income from a summer job          $2,200


    Assuming her parents claim Allison as a dependent, what is her taxable income
    for 2010?
    Allison’s taxable income is $1,500. Because she is claimed as a dependent on her parent’s
    return, she will receive no personal exemption and her standard deduction will be limited to
    the greater of (1) $950 or (2) earned income plus $300, not to exceed the maximum allow-
    able standard deduction.

                         Adjusted gross income ($1,800 + $2,200)               $4,000
                         Standard deduction (earned income plus $300)          (2,500)
                         Personal exemptions                                        (0)
                         Taxable income                                        $1,500
356   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                         15. Billy sold the following investments during the year:

                                                           Description          Holding Period    Gain/(Loss)
                                                           ABC stock              Short term       $30,000
                                                           XYZ stock              Long term        $45,000
                                                           Bonds                  Short term      ($20,000)
                                                           Real estate            Long term       ($60,000)


                               What is the net short-term or long-term gain or loss, and how much must Billy
                               include or deduct in the current year?
                               Billy has a net long-term capital loss of $5,000, of which $3,000 will be deductible in the
                               current year. The remaining loss can be carried forward as a long-term capital loss.

                                                                Short term:
                                                                         Gain                    $30,000
                                                                         Loss                    (20,000)
                                                                         Short-term gain         $10,000

                                                                Long term:
                                                                         Gain                    $45,000
                                                                         Loss                    (60,000)
                                                                         Long-term loss          (15,000)

                                                                Net:
                                                                         Short-term gain         $10,000
                                                                         Long-term loss          (15,000)
                                                                         Net long-term loss       (5,000)
                                                    Chapter 13 | Individual Income Tax and Tax Planning   357




PROBLEMS and SolutionS
        1. David and Sue Dell are married and file a joint return. They have two children,
           Billy and Suzy, ages 8 and 6, respectively.
           David is a self-employed real estate appraiser, and the results for his business for
           the current year are as follows (he paid self-employment tax of $4,700):

                                    Gross receipts                    $50,000
                                    Expenses:
                                    Advertising                         $900
                                    Insurance                          $1,000
                                    Interest                            $500
                                    Dues                                $700
                                    Depreciation                       $1,200
                                    Office rent                       $12,000
                                    Meals and entertainment             $800


           Sue, who is employed by a marketing company, earned a salary of $40,000 for
           the current year. She participates in the company’s 401(k) plan and made con-
           tributions to the plan of $6,000 for the current year (the company does not pro-
           vide any matching contributions).
           David and Sue also received the following income during the year:
            Interest:
            ■■ Second National Bank, Dallas                $1,100
            ■■ State of Louisiana Municipal Bonds            $500


            Qualified dividends:
            ■■ ABC Company cash dividend                     $350
            ■■ XYZ Company cash dividend                     $400


            They sold their principal residence after owning and living in the home for five years.
            The following information relates to the sale of the residence:
            ■■ Sale price                                  $700,000
            ■■ Original cost                               $150,000


            David and Sue incurred the following expenses during the current year:
            ■■ Real estate taxes                           $10,000
            ■■ Mortgage interest                            $4,500
            ■■ Sales taxes                                     $800
358   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                               Assuming David paid $5,000 in alimony to his ex-wife, calculate the Dells’ tax-
                               able income for 2010.
                               Taxable income is $82,700 for 2010, calculated as follows:

                                   Income:
                                                                                          2010
                                   Salary (Sue)                                         $34,000       (401(k) cost is excludable)
                                   Self-employment income (David)                        33,300     (Meals only 50% deductible)
                                   Interest and dividends                                 1,850      (Muni bonds not taxable)**
                                   Sale of residence                                     50,000     ($500,000 gain is excludable)*
                                   Total income                                        $119,150
                                                                                              0

                                   Total income                                        $119,150
                                   Deductions for AGI:
                                   Alimony paid                                           5,000
                                   ½ of SE tax paid                                       2,350
                                   Adjusted gross income                               $111,800
                                   Itemized deductions (sales tax not
                                   deductible):
                                   Real estate taxes                                     10,000
                                   Mortgage interest                                      4,500
                                   Personal exemptions                                   14,600 (3,650 × 4)
                                   Taxable income                                       $82,700
                                   * The $50,000 is taxed at 15% capital gains rate.
                                   ** Dividends (but not interest) are taxed at 15%.




                          2. Scott and Laura Davis are married and file a joint income tax return. They have
                             taxable income for the current year of $65,000. In arriving at taxable income,
                             they took the following deductions:

                                                                    Mortgage interest               $8,000
                                                                    Real estate taxes              $10,000
                                                                    State income taxes              $8,000
                                                                    Charitable deductions             $300
                                                                    Personal exemptions                   2

                               In addition, Scott and Laura received the following tax-exempt interest:

                                                             Municipal bonds                              $600
                                                             Private activity bonds issued in 2005      $3,000
                                                 Chapter 13 | Individual Income Tax and Tax Planning   359


   Laura also exercised incentive stock options during the year. The option entitled
   her to purchase 500 shares at $50 per share. The stock was worth $110 per
   share at the time of exercise.
   Calculate the Davis’ alternative minimum taxable income before considering the
   AMT exemption amount.
      Taxable income                                                             $65,000
    + AMT adjustments
      Real estate taxes                                                           10,000
      State income taxes                                                            8,000
      Personal exemptions ($3,650 × 2)                                            $7,300
      Exercise of incentive stock options [($110 − $50) × 500]                    30,000
    + Tax preferences
      Interest income from private activity bond                                    3,000
    = Alternative minimum taxable income (AMTI)                                 $123,300

3. Steve and Elaine exchange real estate investments. Steve gives up property with
   an adjusted basis of $250,000 (FMV $400,000). In return for this property,
   Steve receives property with a FMV of $300,000 (adjusted basis $200,000) and
   cash of $100,000.
   What are Steve and Elaine’s realized, recognized, and deferred gains because of
   the exchange?
    Steve:
                     Amount Realized
                     FMV of property received                   $300,000
             +       Cash received                                100,000
             =       Total amount realized                      $400,000
             –       Adjusted basis of property given up         (250,000)
             =       Realized gain                              $150,000
             –       Recognized gain (cash received)              100,000
             =       Deferred gain                                $50,000

    Elaine:
                      Amount Realized
                      FMV of property received                                        $400,000
                 +    Cash received                                                            0
                 =    Total amount realized                                           $400,000
                 –    Adjusted basis ($200,000 basis + $100,000 cash paid)            (300,000)
                 =    Realized gain                                                   $100,000
                 –    Recognized gain (cash received)                                          0
                 =    Deferred gain                                                   $100,000
360   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                          4. Anne, a CPA employed by CPAsRUs.com, is an unmarried taxpayer. She earned
                             a salary of $100,000 for the current year (2010) and did not participate in the
                             firm’s 401(k) plan.
                               Anne also received the following income and incurred the following expenses during the
                               year:

                                Income:

                                            Interest                             $2,000
                                            Dividends                              $900


                                Expenses:
                                            Medical (unreimbursed)               $1,500
                                            Real estate taxes                    $7,000
                                            Mortgage interest                    $5,000
                                            Interest on auto loan                $2,500


                               Ignoring any credits, how much lower would Anne’s tax liability have been had she made
                               a deductible employee contribution ($12,000) to the 401(k) plan?
                               Anne would have reduced her tax liability by $3,145.50 (for 2010) by making the maximum
                               contribution to her 401(k) plan.
                               Current tax liability (without contribution to 401(k)):

                                Income:
                                                                                             2010
                                Salary (no 401(k) contributions)                           $100,000
                                Interest and dividends                                        2,900
                                Total income                                               $102,900
                                Total income                                               $102,900
                                Deductions for AGI                                                  0
                                Adjusted gross income                                      $102,900
                                Itemized deductions (sales tax not deductible):
                                   Medical expenses                                                 0
                                   Real estate taxes                                          7,000
                                   Mortgage interest                                          5,000
                                   Interest on auto loan                                            0
                                Personal exemptions                                          $3,650
                                Taxable income                                              $87,250
                                Tax due [$16,781.25 + 28% × ($87,250 – $82,400) +         $18,274.25*
                                15% × 900]
                                * The $900 of dividends are taxed at 15%.
                                                            Chapter 13 | Individual Income Tax and Tax Planning   361


                    Tax liability with contribution to 401(k):

          Income:
                                                                                2010
          Salary after 401(k) contributions                                     $88,000 ($100,000 – $12,000)
          Interest and dividends                                                   2,900
          Total income                                                          $90,900
          Total income                                                          $90,900
          Deductions for AGI                                                            0
          Adjusted gross income                                                 $90,900
          Itemized deductions (sales tax not deductible):
          Medical expenses                                                              0
          Real estate taxes                                                        7,000
          Mortgage interest                                                        5,000
          Interest on auto loan                                                         0
          Personal exemptions                                                      3,650
          Taxable income                                                        $75,250
          Tax due [$4,681.25 + 25% × ($75,250 – $34,000) + 15%              $15,128.75*
          × 900]

          Taxes (no 401(k) contribution)                                     $18,274.25
          Taxes (with 401(k) contribution)                                  ($15,128.75)
          Tax savings due to 401(k) contribution                              $3,145.50
          *The $900 of dividends are taxed at 15%.




❚ ■ CaSE SCEnario and SolutionS
                 Use the information provided to answer the following questions regarding the Nelson
              family.

                                                 NELSON FAMILY CASE SCENARIO
                                                   DAVID AND DANA NELSON
                                                      As of January 1, 2010


              Personal Background and Information
                  David Nelson (age 37) is a bank vice president. He has been employed there for
              12 years and has an annual salary of $70,000. Dana Nelson (age 37) is a full-time home
              maker. David and Dana have been married for eight years. They have two children, John
              (age 6) and Gabrielle (age 3), and are expecting their third child in two weeks. They
              have always lived in this community and expect to remain indefinitely in their current
              residence.
362   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                          Investment Information
                              The bank offers a 401(k) plan in which David is an active participant. The bank
                          matches contributions dollar for dollar up to 3% of David’s salary. David currently con-
                          tributes 5.43% of his salary. His employer’s plan allows for employee contributions of up
                          to 16%. In the 401(k), the Nelsons have the opportunity to invest in a money market
                          fund, a bond fund, a growth and income fund, and a small-cap stock fund. The Nelsons
                          consider themselves to have a moderate investment risk tolerance.


                          Income Tax Information
                              David and Dana tell you that they are in the 15% federal income tax bracket. They
                          pay $820 annually in state and local income taxes.
                                     Chapter 13 | Individual Income Tax and Tax Planning   363


                              Dana and David Nelson
                         Personal Statement of Cash Flows
                                       2009
INCOME
Salary—David                                                                  $70,000
Investment income
Interest income                                            $900
Dividend income                                            $150                $1,050
Total inflow                                                                  $71,050
Savings
Reinvestment (interest/dividends)                       $1,050
401(k) deferrals                                        $3,803
Educational fund                                        $1,000
Total savings                                                                  $5,853
Available for expenses                                                        $65,197
EXPENSES
Ordinary living expenses
Food                                                    $6,000
Clothing                                                $3,600
Child care                                                 $600
Entertainment                                           $1,814
Utilities                                               $3,600
Auto maintenance                                        $2,000
Church                                                  $3,500
Total ordinary living expenses                                                $21,114
Debt payments
Credit card payments principal                             $345
Credit card payments interest                              $615
Mortgage payment principal                              $1,234
Mortgage payment interest                              $20,720
Boat loan principal                                     $1,493
Boat loan interest                                      $1,547
Total debt payments                                                           $25,954
Insurance premiums
Automobile insurance premiums                              $900
Disability insurance premiums                              $761
Homeowners insurance premiums                              $950
Total insurance premiums                                                       $2,611
Tuition and education expenses                                                 $1,000
Taxes
Federal income tax (W/H)                                $7,500
State (and city) income tax                                $820
FICA                                                    $5,355
Property tax (principal residence)                      $1,000
Total taxes                                                                   $14,675
Total expenses                                                                $65,354
Discretionary cash flow (negative)                                             ($157)
364   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                                                                       Dana and David Nelson
                                                                   Statement of Financial Position
                                                                            01/01/2009
                              Assets                                                   Liabilities and net worth
                              Cash/cash equivalents                                    Current liabilities
                              JT        Checking account                 $1,425        JT       Credit cards               $4,000
                              JT        Savings account                    $950        JT       Mortgage on principal      $1,234
                                                                                                residence
                                                                                       H        Boat loan                  $1,493
                              Total cash/cash equivalents                $2,375        Total current liabilities           $6,727
                              Invested assets                                          Long-term liabilities
                              W         ABC Stock                       $12,500        JT       Mortgage on principal    $196,654
                                                                                                residence
                              JT        Educational fund                $14,000        H        Boat loan                 $12,065
                              H         401(k)                          $32,197
                              Total invested assets                     $58,697        Total long-term liabilities       $208,719

                              Personal-use assets                                      Total liabilities                 $215,446
                              JT        Principal residence           $245,000
                              JT        Automobile                      $18,000
                              H         Boat A                          $25,000        Net worth                         $207,626
                              W         Jewelry                         $13,000
                              JT        Furniture/household             $61,000
                              Total personal-use assets               $362,000
                              Total assets                            $423,072         Total liabilities and net worth   $423,072
                                                    Chapter 13 | Individual Income Tax and Tax Planning       365



                                           Dana and David Nelson
                                       Statement of Financial Position
                                                12/31/2009
Assets                                         Liabilities and net worth
Cash/cash equivalents                          Current liabilities
JT        Checking account           $1,268    JT              Credit cards                                $3,655
JT        Savings account             $950     JT              Mortgage on principal residence             $1,370
Total cash/cash equivalents          $2,218    H               Boat loan                                   $1,048
                                               Total current liabilities                                   $6,073
Invested assets                                Long-term liabilities
W         ABC Stock                $14,050     JT              Mortgage on principal residence        $195,284
JT        Educational fund         $15,560     H               Boat loan                                  $16,017
H         401(k)                   $38,619     Total long-term liabilities                            $211,301
H         XYZ Stock                $10,000
Total invested assets              $78,229
Personal-use assets                            Total liabilities                                      $217,374
JT        Principal residence     $250,000
JT        Automobile               $15,000
H         Personal watercraft      $10,000     Net worth                                              $241,573
H         Boat B                   $30,000
W         Jewelry                  $13,500
JT        Furniture/Household      $60,000
Total personal-use assets         $378,500
Total assets                      $458,947     Total liabilities and net worth                        $458,947



     1.    Calculate the Nelsons’ taxable income and tax liability for 2009 (ignoring any
           credits).
            Salary (David)                      $66,197
            Interest income                          900
            Dividends                                150
            Total income                        $67,247
            Deductions for AGI                          0
            Adjusted gross income               $67,247

            Itemized deductions:
               Donations to charity                $3,500
               Mortgage interest                   20,720
               State and local tax                   820
               Property tax                         1,000
            Personal exemptions                 $14,600 ($3,650 × 4)
            Taxable income                      $26,607

            Tax on dividends                    $0 (0% × $150)
            Tax on remaining income             $3,133.55 [$1,670 + 15% × ($26,457 – $16,700)]
            Total tax liability                 $3,133.55
366   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                          2. Are the Nelsons subject to the alternative minimum tax? If so, what is their
                             AMT for 2009?
                               The Nelsons will not be subject to AMT because their AMTI is $29,407 and the AMT
                               exemption is $45,000 for MFJ.
                                                          AMTI = $27,607 + $1,000 + $820 = $29,427.
                          3. The Nelsons exchanged their boat (Boat A) plus $5,000 for Boat B on
                             December 31, 2009. David had paid $22,000 for Boat A a few years ago. What
                             are the realized gain and recognized gain from this transaction?
                               Because personal property is not eligible for the tax advantages of like-kind exchanges, the
                               Nelsons’ realized gain and recognized gain will be the same.

                                                             FMV of Boat B                  $30,000
                                                             Basis in Boat A                (22,000)
                                                             Cash paid for Boat B            (5,000)
                                                             Realized/recognized Gain       $ 3,000

                          4. If David maximized his contributions to his 401(k) plan, what would be the
                             reduction in the Nelsons’ tax liability?
                                Salary (David)                      $58,800 (16% × $70,000 = $11,200)
                                Interest income                          900
                                Dividends                                150
                                Total income                        $57,750
                                Deductions for AGI                          0
                                Adjusted gross income               $57,750
                                Itemized deductions:
                                   Donations to charity              $3,500
                                   Mortgage interest                  20,720
                                   State and local tax                   820
                                   Property tax                        1,000
                                Personal exemptions                 $14,600 ($3,650 × 4)
                                Taxable income                      $17,110


                                Tax on dividends                           $0 (0% × $150)
                                Tax on remaining income             $ 1,709.00 [$1,670 + 15%($16,960 − $16,700)]
                                Total tax liability                 $ 1,709.00
374    Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition




      DISCUSSION QUESTIONS AND SOLUTIONS

                           1. What are the different types of business entities that a businessowner may
                              choose as a legal form of business?
                                A businessowner may choose from a sole proprietorship, partnership, LLP, C corporation,
                                S corporation, or LLC.
                                ■ A sole proprietorship is a business owned and controlled by one person who is personally
                                  liable for all debts and claims against the business.
                                ■ A partnership is an association of two or more entities or individuals that carry on as co-
                                  owners of a business for the purpose of making a profit.
                                ■ An LLP is similar to a general partnership, except an LLP provides additional liability
                                  protection to the partners (only available to limited professions).
                                ■ A corporation (regular C corporation) is an entity created by state law that is separate
                                  and distinct from its owners, who are called shareholders.
                                ■ An S corporation is a special type of corporation for federal income tax purposes. The
                                  corporation is formed like a regular corporation (i.e., limited liability, separate entity)
                                  under state law; however, for income tax purposes, it is treated similarly to a partnership.
                                ■ An LLC is a relatively new type of business entity but is one of the most versatile. An
                                  LLC is created under state law by filing articles of organization. Its owners, referred to as
                                  members, can be individuals, partnerships, trusts, corporations, or other LLCs.
                           2. How is a limited liability partnership (LLP) taxed?
                                For federal income tax purposes, an LLP is treated in the same fashion as a partnership. The
                                LLP is considered a conduit, or flow-through entity, that is not subject to federal income tax.
                                Partners must take into account their distributive share of partnership taxable income and
                                any additional items the partnership is required to report separately.
                           3. What are the differences between general and limited partners?
                                ■ General partnerships are owned entirely by general partners. These general partners may
                                  participate in the management of the partnership business, and they have unlimited
                                  liability for partnership debt both jointly and severally. Each partner can act on behalf of
                                  the partnership.
                                ■ For federal income tax purposes, each general partner’s share of partnership trade or busi-
                                  ness income is considered self-employment income and is subject to self-employment
                                  taxes.
                                ■ A limited partnership is a partnership formed under the limited partnership laws of a
                                  state. The partnership must have at least one general partner and at least one limited
                                  partner. A limited partner is liable to creditors only to the extent of that partner’s con-
                                  tributed capital (this amount also may include amounts promised to be contributed). In
                                  this respect, the limited partner is treated as an investor, limited in liability to the extent
                                  of the amount contributed to the partnership.
                                ■ A limited partner is not allowed to participate in the management and control of the
                                  partnership business and is not subject to self-employment taxes on partnership earnings.
                                                                 Chapter 14 | Business Entities    375


4. How does each type of business entity differ with regard to the personal liability
   of owners?
   ■ With a sole proprietorship, the proprietor has unlimited personal liability for the indebt-
     edness of the sole proprietorship.
   ■ Liability of partners depends on whether the partner is a general or limited partner.
     A general partner has unlimited liability for the acts of the partnership, the other part-
     ners, and obligations made by any partner or the partnership in the performance of part-
     nership duties. If the partnership assets are insufficient to satisfy the liabilities of the part-
     nership, the partnership’s creditors can collect against the personal assets of the general
     partners. A limited partner is liable for partnership indebtedness only to the extent of the
     capital the partner has contributed or agreed to contribute. In this respect, the limited
     partner is treated as an investor, liable only for the amount of his investment.
   ■ In an LLP, partners are personally liable for their own acts of wrongdoing, but their per-
     sonal assets are protected from claims arising from the wrongful acts of other partners.
     This liability protection in many states extends only to tort law, not contract law.
   ■ One of the major advantages of the corporate form of ownership is the limited liability
     enjoyed by shareholders. The shareholders’ liability for the acts, omissions, debts, and other
     obligations of the corporation generally is limited to the shareholders’ capital contributions.
   ■ A member of an LLC has no personal liability for the debts or obligations of the LLC.
     This limited liability applies both to members who participate in management and those
     who do not.
5. What are the tax ramifications of withdrawals or distributions from a C corporation?
   One of the major tax disadvantages of the corporate legal form of business entity is the dou-
   ble taxation of dividends paid by the corporation to its shareholders. Double taxation refers
   to the taxation of income at the corporate level and the subsequent taxation of dividend
   distributions at the individual shareholder’s level. There is no deduction from the taxable
   income of a corporation for dividends distributed to shareholders.
6. What type of business entity should owners choose if they expect the business to
   produce losses in the first few years?
   If the business expects losses, a conduit entity, such as a partnership, S corporation, or LLC
   is generally the entity of choice. Losses will flow through to the owners of the entity and
   generally can be used immediately to offset other income at the individual level.
7. What is the tax treatment of a limited liability corporation?
   An LLC with two or more owners is generally treated as a partnership for federal income
   tax purposes, unless it elects to be treated as a corporation. If the LLC has only one member,
   it is treated as a sole proprietorship. In some states, but not all, a single member LLC can
   normally make an election, such as S corporation tax treatment. If no such election is made,
   the default position is sole proprietor.
   If the LLC is treated as a partnership, the partners must take into account their distributive
   share of partnership taxable income and any separately stated items in computing their indi-
   vidual taxable incomes.
8. What type of business entity should an owner choose if simplicity of formation
   and operation is a major priority?
   If a major factor in the determination of a business legal form is simplicity of formation, the
   sole proprietorship or general partnership is the business form of choice. No special docu-
   ments need to be prepared for a sole proprietorship or general partnership to begin activities.
   However, it is customary for a general partnership to draft a written partnership agreement,
   and the partnership must file a separate income (informational) tax return each year.
376    Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition




      EXERCISES and solutions
                           1. A bookkeeper performed services for ABC Partnership and, in lieu of her nor-
                              mal fee, accepted a 20% unrestricted capital interest in the partnership with a
                              fair market value of $7,500. How much income from this arrangement should
                              the bookkeeper report on her tax return?
                                If a partner contributes services to the partnership, the partner must recognize ordinary com-
                                pensation income for the value of the services. In this case, the bookkeeper must recognize
                                $7,500 of compensation income.
                           2. An S corporation has the following information for its taxable year:

                                                         Net income before the items below          $60,000
                                                         Salary to employee                         (18,000)
                                                         Rental income                              $22,000
                                                         Rental expenses                            (29,000)
                                                         Net income                                 $35,000


                                John is a 40% owner of the S corporation, and he performs services for the busi-
                                ness. What is John’s self-employment income from the corporation, subject to
                                self-employment tax?
                                None of the income from the S corporation is subject to self-employment tax. Income from
                                an S corporation is not considered self-employment income.
                           3. During the year, Susan purchased 5 shares of an S corporation’s 100 shares of
                              outstanding common stock. She held the shares for 146 days during the taxable
                              year. If the S corporation reported taxable income of $200,000, how much must
                              Susan include on her personal income tax return?
                                Susan must include $4,000 on Schedule E of her personal income tax return. She held a 5%
                                interest in the corporation for 146 days during the year.
                                Calculation: $200,000 × 5% × 146/365 = $4,000.
                           4. Alpha Company (a C corporation) owns 25% of Zeta Company. During the year,
                              Zeta Company paid a $30,000 dividend to Alpha Company. For tax purposes,
                              how will Alpha Company treat the dividend received?
                                Alpha will include the $30,000 of dividend income in its gross income but will be entitled
                                to a dividends-received deduction of $24,000 ($30,000 × 80%).
                           5. Nelson received a 70% capital interest in a general partnership by contributing
                              the following:

                                                        Item Transferred           Nelson’s Basis   FMV
                                                        Land                       $60,000          $100,000
                                                        Debt (on land)             N/A              ($50,000)
                                                        Inventory                  $10,000            $8,000
                                                        Services                   N/A               $2,500
                                                              Chapter 14 | Business Entities   377


   What is Nelson’s basis in the partnership after the contribution?
   Nelson’s basis is $57,500, calculated as follows:

                       Basis of land                                $60,000
                       Debt (30% assumed by other partners)         (15,000)
                       Inventory (basis)                            $10,000
                       Services (FMV)                                $2,500
                       Total basis after contribution               $57,500


6. Brooke Industries, Inc. (a C corporation) had the following income and loss
   items during the year:

                       Gross receipts                              $200,000
                       Cost of goods sold                            (50,000)
                       Dividend income from ABC Corp                $20,000
                       (Brooke owns 15% of ABC)
                       Operating expenses                            (40,000)
                       Net operating loss carryforward               (12,000)

   What is Brooke Industries’ taxable income and tax due for the year?
   The tax due on taxable income of $104,000 is $23,810: [($104,000 − $100,000) × 39% +
   $22,250].

                       Gross receipts                              $200,000
                       Cost of goods sold                            (50,000)
                       Gross profit                                $150,000
                       Dividend income from ABC Corp                 $20,000
                       Gross income                                $170,000
                       Deductions:
                       Operating expenses                            (40,000)
                       Dividends received deduction (70%)            (14,000)
                       Net operating loss                            (12,000)
                       Taxable income                              $104,000
                       Tax due                                       $23,810


7. In its first year of business, Sanifone Corp (a C corporation) had gross income
   of $160,000 and deductions of $40,000. The company also paid a dividend
   of $20,000 to its only shareholder, Joe Taylor, who is in the 35% individual
   income tax bracket. What are the tax implications to Sanifone and Joe?
   Sanifone will not receive a deduction for the dividend paid to Joe. Therefore, the corpo-
   ration will have taxable income of $120,000 ($160,000 − $40,000), which will result in
   income tax of $30,050 [($120,000 − $100,000) × 39% + $22,250].
   Joe must report the dividend received as ordinary income on his income tax return. Because
   Joe is in the 35% tax bracket, the dividend he received will result in additional tax of
   $3,000 (15% × $20,000).
378   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                           8. Tommy is a general partner in RichTech, a general partnership. Tommy received
                              a K-1 from the partnership, which contained the following items:

                                                    Partnership taxable income                    $200,000
                                                    Dividend income                                  $2,500
                                                    Long-term capital gain (on investments)          $6,000


                               How much self-employment tax will Tommy have to pay in 2009?
                               Although Tommy must report all items of partnership income, he is required to pay only
                               self-employment tax on the partnership taxable income of $200,000. He would incur
                               $18,779 (for 2009) in self-employment tax, calculated as follows:

                                                                                                    2009
                                                    Net earnings from self-employment             $200,000
                                                    Less 7.65% of net earnings                     $15,300
                                                    Amount subject to self-employment tax         $184,700
                                                    Social Security portion (12.4% × $106,800)     $13,243
                                                    Medicare portion (2.9% × $184,700)              $5,356
                                                    Total self-employment taxes                    $18,779


                               Tommy also will receive a deduction of $9,389.50 (for 2009), which is one-half of the self-
                               employment tax. This amount will be deducted in arriving at adjusted gross income (above-
                               the-line deduction).
                           9. What is the management structure of a C corporation?
                               With a corporation, there is separation of management from ownership so that the mere
                               ownership of corporate stock does not give the owner the right to participate in the manage-
                               ment. The management is centralized, with the directors and officers handling management
                               of corporate affairs.
                               Directors are individuals who, acting as a group known as the board of directors, manage the
                               business and affairs of a corporation. The board of directors is the governing body of a corpo-
                               ration and is elected by shareholders. Directors may be shareholders or individuals with no
                               financial interest in the corporation. The directors are responsible for selecting the officers,
                               supervision, and general control of the corporation.
                               Officers of a corporation are individuals appointed by the board of directors. Like directors,
                               officers may be shareholders or individuals with no financial interest in the corporation. The
                               officers are responsible for carrying out the board’s policies and for making day-to-day oper-
                               ating decisions.
                               The decisions made by the officers and directors are based in part on the corporation’s
                               bylaws. Bylaws are the regulations of a corporation that, subject to statutory law and the
                               articles of incorporation, provide the basic rules for the conduct of the corporation’s business
                               and affairs.
                                                               Chapter 14 | Business Entities   379


10. What are the requirements for an S corporation?
    A corporation must meet all of the following requirements at all times for the S election to
    be initially and continually valid.
    ■ Maximum of 100 shareholders—An S corporation cannot have more than 100 eligible
      shareholders. Beginning after 2004, members of a family who own stock are treated as a
      single taxpayer.
    ■ Eligible shareholders—Ownership of S corporation stock is restricted to individuals
      who are US citizens or residents, estates, certain trusts, and charitable organizations.
      Nonresident aliens, C corporations, and partnerships are prohibited from holding stock in
      an S corporation.
    ■ Domestic corporation—The corporation must be an eligible corporation created under
      the laws of the United States or of any state.
    ■ Eligible corporation—Insurance companies, domestic international sales corporations,
      and certain financial institutions are not eligible for S corporation status.
    ■ One class of stock—The corporation is allowed only one class of outstanding stock. The
      shares generally must provide identical rights to all shareholders. An S corporation may
      have two classes of stock if the only difference is that one class has voting rights and the
      other class does not.
380    Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition




      PRoBlEMs and solutions
                           1. Hugh is a single taxpayer with no children. He is a self-employed real estate
                              appraiser, and the results for his business for the current year are as follows:

                                                             Gross receipts                  $150,000
                                                             Expenses:
                                                             Advertising                          $2,000
                                                             Insurance                            $1,000
                                                             Dues                                 $1,500
                                                             Office rent                         $12,000
                                                             Meals and entertainment               $800

                                Hugh also received the following income during the year:

                                                                       Interest         $1,100
                                                                       Dividends        $1,400

                                Hugh incurred the following expenses during the current year:

                                                             Real estate taxes                    $9,000
                                                             Mortgage interest                    $5,000

                                Assuming Hugh paid $10,000 in alimony to his ex-wife, calculate his taxable income and
                                self-employment tax for tax year 2009.
                                His self-employment tax must be calculated first. He will incur self-employment tax of
                                $16,807.82 (for 2009), calculated as follows:

                                                                                                            2009
                                                    Gross receipts                                          $150,000
                                                    Advertising                                               (2,000)
                                                    Insurance                                                 (1,000)
                                                    Dues                                                      (1,500)
                                                    Office rent                                              (12,000)
                                                    Meals and entertainment (50% deductible)                    (400)
                                                    Net earnings from self-employment                       $133,100
                                                    Less 7.65% of net earnings                               (10,182)
                                                    Amount subject to self-employment tax                   $122,918

                                                    Social Security portion (12.4% × $106,800)             $13,243.20
                                                    Medicare portion (2.9% × $122,918)                      $3,564.62
                                                    Total self-employment taxes                            $16,807.82
                                                                         Chapter 14 | Business Entities         381


   Taxable income is $98,546 (for 2009), calculated as follows:

                                                                              2009
                                Income:
                                Self-employment income                      $133,100
                                Interest and dividends                         $2,500
                                Total income                                $135,600

                                Deductions for AGI:
                                Alimony paid                              ($10,000.00)
                                ½ of self-employment tax paid               ($9,403.51)
                                Adjusted gross income                     $116,196.49

                                Itemized deductions:
                                Real estate taxes                            (9,000)
                                Mortgage interest                            (5,000)
                                Personal exemption (2009)                    (3,650)
                                Taxable income                             $98,546

2. Pete is a single taxpayer with no dependents. During the year, he invested
   $40,000 in an S corporation. He received the following information on the K-1
   from the S corporation:
                                 Net income before salary                        $60,000
                                 Salary to Pete (S corporation)                  $18,000
                                 Interest income                                  $2,000
                                 Qualified dividend income                        $1,000
                                 Long-term capital gain                           $4,500
                                 Charitable contributions                         $2,000

   Pete also received a distribution of $5,500 from the S corporation and earned a salary of
   $50,000 at his full-time job. Calculate Pete’s taxable income.
   His taxable income is $108,150 (for 2009), calculated as follows:

                                                                          2009
       Salary full-time job                                              $50,000
       Salary S corporation                                              $18,000
       Business income (S corporation)                                   $42,000           ($60,000 − $18,000)
       Interest/dividend income (S corporation)                           $3,000
       Long-term capital gain (S corporation)                             $4,500
       Gross income                                                    $117,500
       Deductions for AGI                                                        0
       Adjusted gross income                                           $117,500
       Standard deduction (greater than itemized)                          (5,700)
       Personal exemption                                                  (3,650)
       Taxable income                                                  $108,150
       Note: Pete does not report the $5,500 distribution because his basis in the S corporation is positive.
382   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                               His basis is $82,000, calculated as follows:

                                                Amount invested                                                     $40,000
                                                Increases to basis:
                                                   S corporation taxable income ($60,000 − 18,000)                  $42,000
                                                   Interest/dividend income                                              $3,000
                                                   Long-term capital gain                                                $4,500
                                                Decreases to basis:
                                                   Cash withdrawal                                                       (5,500)
                                                   Charitable contribution                                               (2,000)
                                                Basis at beginning of next year                                     $82,000


                          3. Doug, a single taxpayer, will be starting a new business in 2009. He is not sure
                             whether to operate the business as a C corporation or S corporation. Given the
                             following estimates of income and expenses, determine the total tax that would
                             be due in either scenario.
                                                   Gross profit                                       $150,000
                                                   Operating expenses (excluding salary)              ($60,000)
                                                   Salary paid to Doug                                 $50,000
                                                   Cash distribution to Doug                           $10,000

                               If Doug chooses a C corporation, the total tax will be $13,850 for 2009 ($6,000 at the cor-
                               porate level and $7,850 at the individual level).

                                                                                                    2009
                                            Gross profit                                          $150,000
                                            Operating expenses (excluding salary)                  (60,000)
                                            Salary paid to Doug                                    (50,000)
                                            Taxable income                                         $40,000
                                            Tax at corporate level                                  $6,000     (15% × $40,000)

                                            Salary C corporation                                              $50,000
                                            Dividend income (C corporation)                                                $10,000
                                            Gross income                                                      $50,000      $10,000
                                            Deductions for AGI                                                      0              0
                                            Adjusted gross income                                             $50,000      $10,000
                                            Standard deduction (greater than itemized)                         (5,700)
                                            Personal exemption                                                 (3,650)
                                            Taxable income                                                    $40,650      $10,000

                                            Ordinary income tax rate for $40,650:
                                                           $4,675 + 25% × ($40,650 − $33,950) =                $6,350
                                            Capital gains rate for $10,000 dividend:
                                                                             $10,000 × 15% =                   $1,500
                                                                  Total tax at individual level                $7,850


                               If Doug chooses an S corporation, the total tax will be $17,850 for 2009 ($0 at the corporate
                               level and $17,850 at the individual level).
                                                    Chapter 14 | Business Entities   383


                                                     2009
Gross profit                                              $150,000
Operating expenses (excluding salary)                      (60,000)
Salary paid to Doug                                        (50,000)
Taxable income                                             $40,000
Tax at corporate level                                          $0

S corporation taxable income                   $40,000
Salary S corporation                           $50,000
Dividend income (S corporation) (assume                    $10,000
Doug does not have basis in the corporation)
Gross income                                   $90,000
Deductions for AGI                                   0
Adjusted gross income                          $90,000
Standard deduction (greater than itemized)      (5,700)
Personal exemption                              (3,650)
Taxable income                                 $80,650     $10,000
Ordinary income tax rate for $81,250:
    $4,675 + 25% ($80,650 − $33,950) =         $16,350
Capital gains rate for $10,000 dividend:
                          $10,000 × 15% =      $1,500
               Total tax at individual level   $17,850
                                                       Chapter 15 | Introduction to Retirement Planning   397




DISCUSSION QUESTIONS AND SOLUTIONS

        1. What is the US savings rate?
           After declining over an extended period, the savings rate has increased over the past two
           years as Americans have faced a recession and cut expenses to save more.
        2. List the steps necessary to calculate capital needs analysis.
           Step 1—Calculate WRR. Determine the WRR today by using one of the two methods iden-
           tified earlier (top-down or budgeting).
           Step 2—Determine gross dollar needs. Determine the wage replacement amount in today’s
           dollars from Step 1.
           Step 3—Determine net dollar needs. Reduce the result from Step 2 by any expected Social
           Security benefits in today’s dollars or other benefits that are indexed to inflation.
           Step 4—Calculate preretirement dollar needs on an inflation-adjusted basis. Inflate the
           result from Step 3 to the retirement age at the consumer price index rate to determine the
           first annual retirement payment.
           Step 5—Calculate capital needed at retirement age. Calculate the present value at retire-
           ment of an annuity due for an annual payment equal to the result from Step 4 over the full
           retirement life expectancy (estimate life expectancy conservatively at 90–93) and use the
           inflation-adjusted earnings rate.
        3. What is the difference between capital needs analysis prepared on an annuity
           basis and capital needs analysis prepared by using a capital preservation model? A
           purchasing power presentation model?
           The basic capital needs analysis is a pure annuity concept generally prepared on a pretax basis.
           The annuity concept means that if all of the assumptions happen exactly as expected, the person
           will die exactly at the assumed life expectancy with a retirement account balance of zero. The
           capital preservation model assumes that at life expectancy, as estimated in the annuity model, the
           client has exactly the same account balance as he did at retirement. An even more conservative
           approach to capital needs analysis is the purchasing power preservation model. This model essen-
           tially maintains the purchasing power of the original capital balance at retirement.
        4. What are the four sources of retirement income?
           Social Security, private pension plans, personal savings, and work
        5. What are the two methods for determining the wage replacement ratio?
           The top-down approach and the budgeting approach
        6. Which method for determining the wage replacement ratio is appropriate for a
           client who is 50 years old? Why?
           For a 50-year-old client, the budgeting approach is the appropriate method because it is
           more personalized and it should be possible to use the current budget with adjustments for
           working expense savings and lifestyle changes to determine an accurate estimate of retire-
           ment needs in today’s dollars.
        7. How is financial security defined?
           The ability to generate sufficient cash flow from invested assets to maintain an adequate
           retirement income without employment.
398   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                          8. List the financial factors that affect retirement planning.
                              1.   Retirement needs
                              2.   Savings
                              3.   Inflation
                              4.   Portfolio returns
                              5.   The work life expectancy
                              6.   The retirement life expectancy
                              7.   Sources of retirement income
                          9. Should retirement planning (capital needs analysis) be prepared on a pretax basis
                             or an after-tax basis? Why?
                               Either way; however, generally on a pretax basis because clients are accustomed to it.
                         10. What percentage of retirement income is provided by Social Security for the
                             average retiree?
                               36% (see Exhibit 15.15 in the textbook)
                         11. Does Social Security favor lower- or higher-wage individuals in terms of retire-
                             ment benefits and wage replacement? How and why?
                               Social Security favors the lower-wage individual by using the three-tiered primary insurance
                               amount formula and by placing a ceiling on the wage earner's income that can be included
                               in the calculations.
                         12. What is one of the main goals for many individuals with regard to personal
                             financial planning?
                               The central mission for individuals is long-term financial security and independence.
                         13. When is financial security realized?
                               Financial security is realized when a person is financially secure enough to live at his desired
                               comfort level without the need for employment income.
                         14. What is the WLE?
                               The work life expectancy (WLE) is the period a person is in the workforce, generally
                               30–40 years.
                         15. What is the RWLE?
                               The remaining work life expectancy (RWLE) is the work period that remains at a certain
                               point in time before retirement. For example, a 50-year-old client who expects to retire at
                               age 62 has a RWLE of 12 years.
                         16. How has life expectancy changed since 1981?
                               In 1981, the average life expectancy for a newborn was 73 years. The average life expec-
                               tancy had risen to 77 years for those born in 2000. This increase in life expectancy, and the
                               corresponding increase in RLE, is a direct result of a decline in the death rate, especially the
                               birth mortality rate. The overall death rate has declined due to medical and technological
                               advances in disease diagnoses, cures, and prevention.
                                               Chapter 15 | Introduction to Retirement Planning   399


17. How and why does the timing of savings affect the ultimate amount of
    accumulation?
    When an individual delays saving, he must compensate by saving more. The problem of
    delaying saving is that the power of compounding is lost. The earlier a person saves, the
    greater the number of future compounding periods available before retirement. A greater
    number of compounding periods leads to a lower required savings rate and a larger accumu-
    lation of capital at retirement.
18. How does inflation affect retirement planning?
    Inflation causes a loss of purchasing power. If a retiree has a fixed retirement income beginning
    at age 65 and inflation is 4%, the retiree has a loss in purchasing power of 33% in 10 years,
    54% in 20 years, and 69% in 30 years. While Social Security retirement benefits are inflation
    adjusted, many private pension plans are not. Thus, the financial planner will have to accom-
    modate inflation into any projected retirement needs and advise clients to save accordingly.
19. What adjustments are normally made to the preretirement budget to arrive at the
    retirement budget?
    Adjustments that decrease income needs:
    ■ No longer pay Social Security taxes
    ■ May no longer need to save (or may need to save less than while working)
    ■ May no longer pay home mortgage
    ■ No longer pay work-related expenses
    ■ Auto insurance may be reduced
    ■ Possible lifestyle adjustments
    Adjustments that may increase income needs:
    ■ Increasing cost of health care
    ■ Lifestyle changes
    ■ Increase in travel
    ■ Second home
    ■ Clubs and activities
    ■ Expenditures on family, gifts, and grandchildren
    ■ Increased property taxes
20. What is the wage replacement ratio?
    The wage replacement ratio (WRR) is an estimate of the percentage of annual income
    needed during retirement compared with income earned before retirement. The wage
    replacement ratio, or percentage, is calculated by dividing the amount of income needed on
    an annual basis in retirement by the preretirement income.
21. Does the wage replacement ratio remain constant over the retirement life
    expectancy?
    The 70–80% wage replacement ratio is probably most appropriate from the beginning of
    retirement, regardless of age, to the late 70s. It appears that consumption for persons past age
    80 declines primarily due to limited mobility. While this may be correct for society at large,
    there are certain individuals who will incur dramatic medical costs during the latter part of
    the retirement period.
400   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                         22. What wage replacement ratio does Social Security provide for a worker with
                             $20,000 income?
                               48% (see Exhibit 15.16 in the textbook)
                         23. What is capital needs analysis?
                               Capital needs analysis is the process of calculating the amount of investment capital needed
                               at retirement to maintain the desired retirement lifestyle and mitigate the impact of infla-
                               tion during the retirement years.
                         24. What advanced models are used to perform capital needs analysis?
                               The capital preservation (CP) model and the purchasing power preservation (PPP) model
                                                   Chapter 15 | Introduction to Retirement Planning   401




EXERCISES AND SOLUTIONS

        1. Donna, age 45, is self-employed and currently earns $70,000. She is fairly set-
           tled in her lifestyle. She currently saves 15% of her gross income. Her mortgage
           payment (principal and interest) is fixed at $1,166.67 per month. She has sched-
           uled her mortgage payments to cease at retirement. On the basis of the informa-
           tion given, what do you expect Donna’s wage replacement ratio to be?
            Salary         $70,000         100%
            FICA           ($9,891)        (15.3% of $64,645)       Self-employed
            Savings       ($10,500)        (15.0%)                  Savings
            Mortgage      ($14,000)                                 Mortgage paid off (1,166.67 × 12)
                           $35,609
            35,609 ÷ 70,000 = 50.87% WRR



        2. Kim, age 30, begins saving $2,500 per year at year-end, continues for 8 years,
           and then stops saving. Joy, age 40, begins saving $2,500 per year at year-end
           and saves continuously until age 65. Assume that both Kim and Joy earn a 12%
           return compounded annually. Calculate the total amount of savings and the accu-
           mulated balance for Kim and Joy, respectively, at age 65. Explain the difference.
                                KIM                                                JOY
            PV              0                             PV                  0
            n               8                             n                   25
            i               12                            i                   12
            PMTOA           $2,500                        PMTOA               $2,500
            FV@38           30,749.23                     FV@65               $333,334.68

            PV@38           30,749.23

            i               12                            Investment (25 × $2,500 = $62,500)

            n               27
            PMTOA           0
            FV@65           $655,723.72
            Investment (8 × $2,500 = $20,000)

           The difference in the accumulation ($635,723.72 − $333,334.68) is due to the longer,
           35-year, compounding period for Kim versus the 25-year compounding period for Joy.
           Use the following information for Exercises 3–10:
           Mike, age 48, currently has $60,000 saved for retirement. He is currently saving 10%
           of his annual income of $50,000 on a monthly basis. His employer matches his savings
           contributions with $1,500 annually, paid on a monthly basis. Mike projects that inflation
           will be 3.5% and he can earn 9.5% before and during retirement. Mike needs a wage
           replacement ratio of 75% of his preretirement income. He plans to retire at age 62 with
           Social Security benefits of $10,000 in today’s dollars. His life expectancy is age 90.
402   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                          3. How much will Mike’s salary be at age 62 assuming his income increases yearly
                             equal to the inflation rate?
                                                                           PV = 50,000
                                                                           i    = 3.5
                                                                           n    = 14
                                                                           FV = $80,934.73
                          4. How much are the Social Security benefits expected to be at age 62?
                                                                           PV = 10,000
                                                                           i    = 3.5
                                                                           n    = 14
                                                                           FV = $16,186.95
                          5. What will be Mike’s retirement income need in the first year of retirement, tak-
                             ing into consideration his anticipated Social Security income?
                                  Current salary                                       $50,000
                                  WRR                                                  ×   .75
                                                                                       37,500
                                  Less Social Security                                 (10,000)
                                  Income need in today’s dollars                       $27,500


                                  Inflation-adjusted income need at age 62             $44,514.10 [PV = 27,500, i = 3.5, n = 14]
                          6. How much capital will Mike need at age 62 to fund his retirement?
                                                         n           = 28 [90 − 62]
                                                         i           = 5.7971 [(1.095 ÷ 1.035) – 1] × 100
                                                         PMTAD = $44,514.10 (from above)
                                                         FV    = 0
                                                         PV@62 = $644,697.05
                          7. How much will Mike have at age 62, assuming he continues his current savings
                             and investment program?
                                                             n          = 168 (14 × 12)
                                                             PV         = 60,000
                                                             i          = 0.7917 [9.5 ÷ 12] (monthly)
                                                             PMTOA = 541.67 [6,500 ÷ 12] (monthly)
                                                             FV    = $414,608.27
                                                       Chapter 15 | Introduction to Retirement Planning         403


 8. How much additional monthly savings would be required for Mike to retire at
    age 62?
                                           FV           = $644,697.05
                                           n            = 168
                                           PV           = –$60,000
                                           i            = 0.7917 [9.5 ÷ 12]
                                           PMTOA = $1,201.33
    $1,201.33 − $541.67* = $659.66 additional monthly savings required
    *541.67 = Mike’s current monthly savings
 9. After reflection, Mike wants to know at what age he can retire, assuming he
    continues to follow his current savings plan. Make a schedule for years 62, 64,
    and 66 so Mike can make informed decisions.

                                      62                       64                             66
             Needs*                   $644,697.05               $669,185.47                   $691,152.79
             Capital**                $414,608.27               $515,245.14                   $636,849.22
             Over (short)             ($230,088.78)            ($153,940.33)                   ($54,303.57)
             *The needs reflect a change in the start of retirement and a reduced retirement life expectancy.
             **The capital is determined by increasing the term of periods (168 at 62, 192 at 64, 216 at 66)


                                                      At age 64                  At age 66
                            Current needs             $27,500.00                 $27,500.00
                            n                         16                         18
                            inflation                 3.5                        3.5
                            FV                        $47,684.62                 $51,080.95

    Capital needs calculation:

                                  At age 64                               At age 66
                n                 26 (90 − 64)                            24 (90 − 66)
                i                 (1.095 ÷ 1.035 − 1) × 100               (1.095 ÷ 1.035 − 1) × 100
                PMTAD             $47,684.62                              $51,080.95
                FV                0                                       0
                PV                $669,185.47                             $691,152.79

10. You remind Mike that if he waits until age 66 to retire, he will receive $14,344
    in Social Security benefits in today’s dollars rather than the reduced benefit of
    $10,000 he would receive at age 62. Would this additional cash flow suggest
    that he could retire at age 66? Perhaps earlier?
                                 Current salary                                $50,000
                                 WRR                                              × .75
                                                                                 37,500
                                 Less Social Security                          (14,344)
                                 Income need in today’s dollars                $23,156
404   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition



                                                                   PV           = $23,156
                                                                   i            = 3.5 (inflation)
                                                                   n            = 18 (66 – 48)
                                                                   FV           = $43,012
                               Capital needs analysis:

                                                      n            = 24 (90 − 66)
                                                      PMTAD = 43,012
                                                      i     = (1.095 ÷ 1.035 – 1) × 100
                                                      FV           = 0
                                                      PV@66        = $581,975.54 Capital needed at age 66,
                                                                     assuming annual Social Security income
                                                                     of $14,344
                               He expects to have $636,849.22 so he can retire at age 66 and possibly at age 65.
                         11. Marion, age 65, is a pensioner who receives a fixed pension of $17,500 for life
                             from her employer’s pension plan. Marion also receives $12,000 currently from
                             Social Security. Marion is concerned about how inflation will affect her rent, food,
                             and other expenses. She estimates that inflation will be 3% per year for the next 10
                             years. What loss of purchasing power will she have in today’s dollars in 10 years?
                                                              Pension                Social Security   Total
                                                 PV           $17,500.00             $12,000.00        $29,500.00
                                                 i            3                      3
                                                 n            10                     10
                                                 FV           $23,518.53             $16,127.00        $39,645.53

                               Mary will only have $17,500 + $16,127.00 = $33,627.00 in 10 years and will need
                               $39,645.53 to maintain her purchasing power. Her loss equals 15.18% [1 – (33,627.00 ÷
                               39,645.53) = .1518 ]. The Social Security benefit is indexed to inflation, while the pension
                               benefit is not.
                         12. George, a financial planner, has determined that Dennis, his client, needs $2 mil-
                             lion at age 66 to retire by using an annuity model based on a retirement income
                             of $150,337.75 per year for 24 years to age 90. If the earnings rate was 10%
                             and the inflation rate was 3%, what additional amount would be needed at age
                             66 to provide a capital preservation model solution?
                                                                           n        = 24
                                                                           i        = 10
                                                                           FV       = $2,000,000
                                                                           PV@66 = $203,051
                               An additional $203,051 is needed at age 66 to fund a capital preservation model.
                         13. Referring to Exercise 12, how much would Dennis need at age 66 to fund a pur-
                             chasing power preservation model?
                                                          n              = 24
                                                          i              = 6.7961 [(1.10 ÷ 1.03) − 1) × 100]
                                                          FV             = $2,000,000
                                                          PVAD@66 = 412,762
                                                    Chapter 15 | Introduction to Retirement Planning   405




PROBLEMS AND SOLUTIONS

            Bill, age 45, wants to retire at age 60. He currently earns $60,000 per year. His goal
       is to replace 80% of his preretirement income. He wants the retirement income to be
       adjusted for inflation. Bill has an investment portfolio valued at $150,000, which is cur-
       rently earning 10% average annual returns. Bill expects inflation to average 3% and,
       based on his family health, he predicts he will live to age 90. Bill is currently saving 7% of
       his gross income at each year-end and expects to continue this level of savings. Bill wants
       to ignore any Social Security benefits for purposes of retirement planning.
        1. What will Bill’s annual needs be at age 60?
                                                Salary      $60,000
                                                WRR         0.80
                                                            $48,000

                                                PV = $48,000
                                                i   = 3
                                                n   = 15
                                                FV = $74,782.44
        2. Will the need be for an ordinary annuity or an annuity due?
           Annuity due
        3. How much total capital will Bill need at age 60?
                                 PMTAD = $74,782.44
                                 n     = 30
                                 i        = (1.10 ÷ 1.03 – 1) × 100 = 6.79612
                                 FV       = 0
                                 PV       = $1,011,685.49
        4. How much capital will Bill have at age 60?
                                           PV            = $150,000.00
                                           n             = 15
                                           PMTOA = $4,200.00
                                           i     = 10%
                                           FV            = $760,031.65
        5. Will Bill have enough income at retirement?
           No
406   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                          6. What is the earliest age that Bill could retire utilizing the current savings and
                             investment plan?
                               Age 63
                                At age                         60                61                62                 63           64
                                FV of capital*                 $760,031          $840,235          $928,458           $1,025,504   $1,132,255
                                Needs requirement**            $1,011,685        $1,000,576        $988,712           $976,041     $962,509
                                Overage (deficit)              $(251,654)        $(160,341)        $(60,254)          $49,463      $169,746
                                *The future value of capital is calculated by changing the n in Question #4 from 15 through 19.
                                **The needs requirement is calculated by changing the n in Question #3 from 30 through 26.


                          7. How much would Bill need to increase his savings on an annual basis to meet his
                             goal of retiring at age 60?
                                                           FV            = $1,011,685.49
                                                           PV            = – $150,000.00
                                                           i             = 10%
                                                           n             = 15
                                                           PMTOA = $12,120.50 – $4,200.00 = $7,920.50
                               Bill would need to increase his savings by $7,920.50 per year to meet his goal of retiring at
                               age 60.
                          8. Even assuming that Bill increases his savings to an appropriate amount, what are
                             the risks that may affect the success of the plan?
                              1. Bill may live too long and run out of money.
                              2. Bill may not earn 10% on investments.
                              3. Bill’s needs may change upward.
                              4. Inflation may be greater than expected.
                              5. Bill may not continue to save at the appropriate level.
                          9. How could the capital needs analysis be modified to reduce the risks identified
                             above?
                              1. Set the life expectancy at 95.
                              2. Use a slightly lower earnings rate.
                              3. Use a slightly higher inflation rate.
                              4. Monitor all variables each year.
                              5. Have Bill increase savings or be flexible about retiring at age 60.
                              6. Reevaluate the decision to exclude Social Security benefits even though he will
                                 not be eligible until age 62.
                              7. Discuss whether working in retirement is an option for Bill to generate additional
                                 income.
                                                                 Chapter 16 | Basic Retirement Plans   419




DISCUSSION QUESTIONS AND SOLUTIONS

        1. What is a qualified retirement plan?
           Qualified retirement plans are either employer or self-employed sponsored plans. The word
           qualified means that the plan meets Internal Revenue Service requirements.
        2. What are the advantages of a qualified retirement plan, and what are its
           disadvantages?
           Advantages include employer contributions are not subject to federal income tax or payroll
           tax, employee contributions are not subject to federal income tax, earnings are tax deferred,
           special income tax averaging may be available, distributions of employer securities may
           be eligible for net unrealized appreciation tax treatment, and special ERISA protection is
           available.
           Disadvantages include the costs to qualify the plan, costs to fund the plan, costs of admin-
           istering the plan, the annual compensation limit, eligibility requirements, coverage require-
           ments of employees, vesting requirements, top-heavy rules, disclosure requirements, and
           annual testing of qualified retirement plans.
        3. What is vesting?
           Vesting is the process by which employees increase their nonforfeitable right to benefits pro-
           vided by an employer’s contribution.
        4. What are the accepted vesting schedules?
           The standard vesting schedules preapproved by the Internal Revenue Service for defined
           benefit plans that are not top-heavy are 5-year cliff and 3-to-7-year graduated vesting. If
           a defined benefit plan is top-heavy, it must use one of the accelerated vesting schedules.
           Vesting schedules for all employer contributions made to defined contribution plans must
           use one of the accelerated vesting schedules, either a 3-year cliff or 2-to-6-year graduated
           vesting, or a more liberal vesting schedule.
        5. Why were qualified retirement plans created?
           Congress created or approved qualified retirement plans (qualified means that the plan
           meets Internal Revenue Service requirements) to encourage retirement savings.
        6. What are the benefits of tax deferral in a qualified retirement plan and how can
           they be calculated?
           Assets contributed to a qualified retirement plan are held in trust for the benefit of the plan
           participants or their beneficiaries. Qualified retirement plan trusts are tax-exempt entities.
           Earnings accruing from contributions from both employers and employees grow income tax
           deferred until distributed. The tax-deferred growth of both contributions and earnings is a
           major benefit that qualified retirement plans provide. The tax savings can be calculated eas-
           ily by calculating the future value of all payments on an after-tax basis.
        7. What are the different types of qualified retirement plans?
           Qualified retirement plans include defined benefit plans, cash-balance plans, money-pur-
           chase pension plans, target benefit plans, profit-sharing plans, stock bonus plans, employee
           stock ownership plans, 401(k) plans, thrift plans, and age-based profit-sharing plans.
420   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                           8. How do pension plans and profit-sharing plans differ?
                                Plan Features                      Pension Plans                  Profit-Sharing Plans
                                In-service withdrawals             Permitted only for employees   Permitted after 2 years
                                                                   age 62 and over
                                Mandatory Funding                  Yes                            No
                                Percentage of employer             10%                            100%
                                stock permitted in the plan
                                Employer contribution limit        25% of covered compensation 25% of covered compensation
                                                                   for defined contribution plans


                           9. How do defined benefit plans and defined contribution plans differ?
                               Under a defined benefit plan, the contributions are actuarially determined to produce a
                               certain series of future benefit payments at retirement. Defined contribution plans specify
                               the annual employer current contribution (as opposed to an ultimate future benefit). The
                               amount of benefit an employee receives depends on the account balance at retirement.
                         10. How do noncontributory plans and contributory plans differ?
                               The employee makes contributions to contributory plans; conversely, the employer makes all
                               contributions under noncontributory plans.
                         11. What is a 401(k) plan, and how does it operate?
                               The 401(k) plan permits an employee to save, pretax, up to $16,500 for the years 2009 and
                               2010 or a certain percentage of income per year (indexed to inflation); and in some cases,
                               that savings is matched, or partially matched, by the employer. Common matching formulas
                               allow the employee to contribute up to 6% of salary with the employer matching $0.50 on
                               the dollar contributed by the employee, up to a total of 3% per year. The employee generally
                               may contribute more than the matched percentage, but the employer match usually does not
                               exceed 3%.
                         12. How do Keogh plans and corporate plans differ?
                               The calculation of the maximum contribution allowed by the self-employed person is the
                               main difference (.25 ÷ 1.25 = .20).
                         13. What are some examples of tax-advantaged, but nonqualified, retirement plans?
                               ■ IRA
                               — Deductible
                               — Nondeductible
                               — Roth IRA
                               ■ SEP
                               ■ SIMPLE
                               — SIMPLE IRA
                               — SIMPLE 401(k)
                               ■ 403(b) plans
                         14. What are IRAs, SEPs, SIMPLEs, and 403(b) plans?
                               ■ The IRA is a tax-deferred investment and savings account that serves as a personal retire-
                                 ment fund for persons with earned income.
                                                          Chapter 16 | Basic Retirement Plans    421


    ■ A SEP is a tax-deferred noncontributory retirement plan that is employer-sponsored and
      is similar to a qualified profit-sharing plan with regard to funding requirements and con-
      tribution limits.
    ■ A SIMPLE IRA plan is a tax-deferred, employer-sponsored retirement plan that more
      closely resembles an IRA plan. A SIMPLE 401(k) combines the employer-sponsor limits
      and requirements with some of the features of a 401(k) plan.
    ■ A 403(b) plan is a tax-deferred savings and retirement plan that, while not a qualified
      plan, provides many of the same benefits and is governed by many of the same rules that
      govern qualified retirement plans.
    ■ All four are nonqualified, but tax-advantaged, plans.
15. How are distributions from qualified retirement plans and other tax-advantaged
    retirement plans the same and how do they differ?
    Distributions from qualified retirement plans and other tax-advantaged plans generally are
    subject to the following income tax treatment.
    ■ If the contributions were pretax, then both contributions and earnings are treated as ordi-
      nary income equal to the distribution, and thus receive ordinary income tax treatment.
    ■ If the contributions were after tax (thrift plan and nondeductible IRA), the contribu-
      tions are treated as a nontaxable return of capital and the earnings are treated as ordinary
      income. Each distribution is prorated as to return of taxable basis and ordinary income
      subject to income tax. The two common exceptions to the general income tax treatment
      of distributions from tax-advantaged retirement accounts include Roth IRA distributions
      and lump-sum distributions consisting of employer securities.
    ■ In general, distributions made before age 59½, death, disability, or retirement are penal-
      ized by a premature penalty tax of 10%
16. What is a nonqualified plan and what are some examples of this type of plan?
    A nonqualified plan is any retirement plan, savings plan, or deferred-compensation plan
    or agreement that does not meet the tax requirements of the Internal Revenue Code.
    Nonqualified plans include deferred-compensation plans, split-dollar life insurance plans,
    and employee stock option plans.
17. Why are nonqualified plans useful to employers?
    Employers use nonqualified plans to provide additional financial benefits that are not, or
    cannot be, provided in qualified retirement plans. Nonqualified plans can reward employees
    (usually key executives) on a more selective basis than qualified retirement plans that require
    broad participation, coverage, and nondiscrimination.
18. Which qualified retirement plans permit in-service withdrawals?
    All qualified plans can permit in-service withdrawals. Pension plans allow in-service with-
    drawals only to employees age 62 and over.
19. Which qualified retirement plans require immediate vesting of employer
    contributions?
    401(k) plans require immediate vesting of all salary-deferral contributions. Otherwise, none
    of the qualified plans require immediate vesting. However, a qualified plan requiring two
    years of service for participation eligibility must also use 100% immediate vesting. SEPs,
    403(b) plans, and IRAs are examples of tax-advantaged plans that require immediate vesting.
422    Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition




      EXERCISES AND SOLUTIONS

                           1. Shawna, a 73-year-old single taxpayer, retired two years ago and is receiving a
                              pension of $700 per month from her previous employer’s qualified pension plan.
                              She recently started a new job with a discount retail outlet that has no pension
                              plan. She will receive $12,000 in compensation from her current job, as well as
                              the $8,400 from her pension. How much can she contribute to a deductible IRA
                              this year in 2010?
                                Shawna will not be able to contribute anything to a traditional, deductible IRA because she
                                is older than 70-1/2 years. She could, however, contribute to a Roth IRA.
                           2. How much can the following individuals contribute to a deductible IRA in
                              2010? Assume that none of the persons listed or their spouses participate in an
                              employer-sponsored pension plan.

                                              Person         Marital Status         AGI       Maximum Contribution
                                              Larry          Single                 $32,000   $5,000
                                              Mark           Married                $87,000   $5,000 + $5,000 spousal
                                              Lee Anne       Single                 $56,000   $5,000
                                              Dennis         Married              $120,000    $5,000 + $5,000 spousal

                           3. Tom and Denise, both age 45, are married and filed a joint income tax return for
                              2010. Tom earned a salary of $70,000 in 2010. Tom and Denise earned interest
                              of $5,000 in 2010 on their joint savings account. Denise is not employed, and
                              the couple had no other income. What amount could Tom and Denise contribute
                              to IRAs for the year 2010 to take advantage of their maximum allowable IRA
                              deduction on their 2010 tax return?
                                Denise and Tom can contribute $10,000 into their IRAs—$5,000 each.
                           4. Evan and Jody, both age 52, are married and filed a joint income tax return for
                              2010. Their 2010 adjusted gross income was $100,000. The couple had no
                              other income, and neither spouse was covered by an employer-sponsored pension
                              plan. What amount could Evan and Jody contribute to IRAs for 2010 to take
                              advantage of their maximum allowable IRA deduction on their 2010 tax return?
                                They can each contribute $6,000 for a total of $12,000—$5,000 of regular contribution and
                                a $1,000 catch-up because each is older than age 50.
                           5. Darlene and Rick are married and file a joint income tax return. They are both
                              covered by a qualified retirement plan. Their 2010 adjusted gross income was
                              $85,000. The couple had no other income. Assuming the couple is under age
                              50, what amount could Darlene and Rick contribute to a Roth IRA this year?
                                They can each contribute $5,000, with a total of $10,000 to a Roth IRA.
                           6. In January of the current year, Phil (age 47) took a $500,000 premature dis-
                              tribution from a rollover IRA, leaving a balance in his IRA of $1 million. On
                              October 31 of the current year, Phil died with the IRA account balance of
                              $1.2 million. Which penalty or penalties will apply to Phil as a result of these
                              facts?
                                The 10% early withdrawal penalty will apply to the $500,000 withdrawal only.
                                                        Chapter 16 | Basic Retirement Plans   423


 7. What is the maximum deductible contribution to a defined contribution qualified
    pension plan on behalf of Ann, a self-employed individual whose income from
    self-employment is $25,000 and whose Social Security taxes are $3,532?

                        Income                                  $25,000.00
                        Less ½ Social Security ( .5 × $3,532)     (1,766.00)
                                                                $23,234.00
                        Overall maximum limit                        × 0.20
                                                                 $4,646.80

 8. Refer back to the previous exercise concerning Ann, the self-employed person.
    What is the maximum Ann could contribute to a profit-sharing plan?

                       Income                                    $25,000.00
                       Less ½ Social Security ( × $3,532)         (1,766.00)
                                                                 $23,234.00
                       Profit-sharing limit                           × 0.20
                                                                  $4,646.80

 9. Robbins, Inc., a regular C corporation, is considering the adoption of a qualified
    retirement plan. The company has had fluctuating cash flows in the recent past,
    and such fluctuations are expected to continue. The average age of nonowner
    employees is 24, and the average number of years of service is 3, with the high
    being 4 and the low 1. Approximately 25% of the 12-person labor force turns
    over each year. The 2 owners receive about two-thirds of the total covered com-
    pensation. Which is the most appropriate vesting schedule for Robbins, Inc.?
    Based on the information given, the plan will most likely be top heavy and should use either
    a 3-year cliff and 2-to-6-year graduated. The 2-to-6-year graduated will probably be better
    from a cash flow point of view considering turnover and longevity of employees.
10. What is the minimum number of employees that must be covered in a defined
    benefit plan to conform to ERISA requirements for a company having 100
    eligible employees?
    The company must cover 40 employees. Defined benefit plans have a minimum coverage
    test of 50 employees or 40% of eligible employees, whichever is less.
424    Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition




      PROBLEMS AND SOLUTIONS

                           1. XYZ Company has 2 employees: John, who earns $300,000 annually, and
                              his assistant, Kim, age 26, who has worked for John for 4 years. Kim makes
                              $20,000. XYZ has a contributory pension plan using graduated vesting. Kim’s
                              account balance reflects the following:

                                               Contributions              Earnings from Contributions          Kim’s Total Balance
                                     Employee             Employer          Employee            Employer
                                     $1,500               $2,000              $800               $1,200              $5,500

                                Reviewing the account and assuming that Kim terminated employment when the
                                account balance was as above after 4 years of employment, how much could she
                                take with her, plan permitting?

                                                                                          Kim        Employer
                                                             Contributions              $1,500       $2,000
                                                             Earnings                     800         1,200
                                                             Account Balance            $2,300       $3,200
                                                             Vested Percentage          ×100%        × 60%
                                                             Vested Amount              $2,300       $1,920


                                Kim can take $4,220 because she is vested for 4 years (60%) in a top-heavy plan. This can
                                be seen by the salary disparity of John to Kim.
                           2. The following table contains qualified plan information for Yarbrough, Inc., as
                              of 12/31/2009. Yarbrough, Inc., maintains a noncontributory qualified plan with
                              cliff vesting.
                                                                             Ownership              Years of         Plan Account
                                      Employee       Compensation             Interest              Service*           Balance*
                                          A            $250,000                  5%                       2           $ 20,000
                                           B           $180,000                  8%                   10              $300,000
                                          C            $120,000                  6%                       8           $180,000
                                          D              $60,000                 1%                       3            $27,000
                                           E             $40,000                 0%                       2              $7,500
                                     * as of 12/31/2009

                                Please answer all of the following questions:
                                A. What is the total covered compensation for 2009?

                                                                                   2009
                                                                                 $245,000
                                                                                 $180,000
                                                                                 $120,000
                                                                                   $60,000
                                                                                   $40,000
                                                                                 $645,000
                                                     Chapter 16 | Basic Retirement Plans   425


B. What would be the maximum profit-sharing contribution Yarbrough could make in
   2009?
                                $645,000 × 0.25 = $161,250
C. Which of the employees are highly compensated?
    A—Income more than $110,000 in previous year
    B—Income more than $110,000 and more than 5% owner
    C—Income more than $110,000 and more than 5% owner
D. Is the plan top heavy?
    Yes, greater than 60% of the benefits go to A, B, and C.
E. If D and E quit in January 2010, how much do they take with them, plan
   permitting?
    D takes $27,000 due to the 3-year cliff top-heavy vesting.
    E takes $0 due to the top-heavy cliff vesting.
                                                                Chapter 17 | Introduction to Estate Planning   445




DISCUSSION QUESTIONS AND SOLUTIONS

        1. What is estate planning, and what are its objectives?
           Estate planning is the process of accumulation, management, conservation, and transfer of wealth
           considering legal, tax, and personal objectives. The objectives of estate planning include:
           ■ transferring (distributing) property to particular persons or entities consistent with client
             wishes;
           ■ minimizing all taxes (income, gift, estate, state inheritance, and generation-skipping taxes);
           ■ minimizing the transaction costs associated with the transfer (costs of documents, law-
             yers, and the legal probate process); and
           ■ providing liquidity to the estate of the decedent at the time of death to pay for costs,
             which commonly arise, such as taxes, funeral expenses, and final medical costs.
        2. What risks are associated with failing to plan for an estate transfer?
           The risks associated with failing to plan for an estate transfer include the following:
           ■ Client’s property transfer wishes go unfulfilled.
           ■ Taxes are excessive.
           ■ Transfer costs are excessive.
           ■ Client’s family not properly provided for.
           ■ Insufficient liquidity to cover client’s debts and taxes.
        3. Which professionals make up the estate planning team?
           The estate planning team consists of the attorney, accountant, life insurance consultant,
           trust officer, and financial planner.
        4. What steps make up the estate planning process?
           There are eight basic steps to the estate planning process.
         1.   Gather client information, including the client’s current financial statements.
         2.   Establish the client’s transfer objectives, including family and charitable objectives.
         3.   Define any problem areas, such as the disposition of assets, liquidity issues, excessive taxes
              or costs, and other situational needs, such as disability of an identified heir.
         4.   Determine the estate liquidity needs now and at five-year intervals for the life expectancy
              of the transferor, including estate transfer costs.
         5.   Establish priorities for all client objectives.
         6.   Develop a comprehensive plan of transfer consistent with all information and objectives.
         7.   Implement the estate plan.
         8.   Review the estate plan periodically, and update the plan when necessary (especially for
              changes in family situations).
446   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                          5. What client information needs to be gathered to begin a successful estate transfer?
                               To begin the estate planning process, the planner should collect the following:
                               ■ Current financial statements
                               ■ Family information (i.e., parents, children, ages, health)
                               ■ A detailed list of assets and liabilities, including the fair market value, adjusted taxable
                                 basis, and expected growth rate for all assets, how title is held, and the date acquired
                               ■ Copies of medical and disability insurance policies
                               ■ Copies of life insurance policies in force identifying the ownership of the policy, the
                                 named insured, and the designated beneficiaries
                               ■ Copies of annuity contracts
                               ■ Copies of wills and trusts
                               ■ Identification of powers of appointment
                               ■ Copies of all previously filed income tax and gift tax returns (as available)
                               ■ Identification of assets previously gifted
                               ■ Other pertinent information
                          6. What are some common estate transfer objectives?
                               Common estate transfer objectives are as follows:
                               ■ Minimize estate and transfer taxes to maximize the assets received by heirs
                               ■ Avoid the probate process
                               ■ Use lifetime transfers—gifts
                               ■ Meet liquidity needs at death
                               ■ Plan for children
                               ■ Plan for the incapacity of the transferor
                               ■ Provide for the needs of the surviving spouse of the transferor
                               ■ Fulfill charitable intentions of the transferor
                          7. What are the basic documents used in estate planning?
                               The basic documents used in estate planning include wills, living wills or advance medical
                               directives, durable powers of attorney for health care or property, and side letters.
                          8. What is the probate process, and what are its advantages and disadvantages?
                               Probate is the legal process that administers a decedent's estate and supervises the orderly
                               distribution of assets to heirs.
                               Advantages of the probate process include the following:
                               ■ Protects creditors by ensuring that the debts of the estate are paid prior to distribution to
                                 heirs
                               ■ Implements the disposition objectives of the testator of the valid will
                               ■ Provides clean title to heirs or legatees
                               ■ Increases the chances that all parties in interest have notice of the proceedings and,
                                 therefore, a right to be heard
                               ■ Provides for an orderly administration of the decedent’s assets
                                                   Chapter 17 | Introduction to Estate Planning   447


    Disadvantages of the probate process
    ■ Costly (legal notice requirement, attorney fees, and court costs)
    ■ Complex
    ■ Delays (caused by identification of property, valuation, identification of creditors and
      heirs, court delays, conflicts, and filing of taxes)
    ■ Real property located in a state outside the testator’s domicile will require a separate
      ancillary probate in that state
    ■ Loss of privacy because probate is open to public scrutiny
 9. Why is having a will important?
    Any of the following could occur if an individual does not have a valid will.
    ■ The state directs how the decedent’s property is transferred.
    ■ A surviving spouse may have to share the estate with the deceased's relatives.
    ■ Children may be treated equally although not equitably.
    ■ May require the appointment of an administrator who will usually have to furnish a sure-
      ty bond, thereby raising the costs of administration.
    ■ The administrator of the estate is determined by the court.
10. What are the three types of wills, and how do they differ?
    ■ Holographic wills are handwritten.
    ■ Oral (nuncupative) wills are dying declarations made before sufficient witnesses.
    ■ Statutory wills are generally drawn by an attorney, complying with the statutes for wills of
      the domiciliary state.
11. What are some provisions typically found in wills?
    Some provisions that are typically included in wills are the following:
    ■ An introductory clause to identify the testator
    ■ The establishment of the testator’s domicile and residence
    ■ A declaration that this is the last will and testament of the testator
    ■ A revocation of all prior wills and codicils by the testator
    ■ The identification and selection of the executor and successor executor by the testator
    ■ A directive for the payment of debts clause
    ■ A directive for the payment of taxes clause
    ■ A disposition of tangible personal property clause
    ■ A disposition of real estate clause (i.e., residence)
    ■ Clauses regarding specific bequests of intangibles and cash
    ■ A residuary clause (the transfer of the balance of any other assets to someone or to some
      institution)
    ■ An appointment and powers clause, naming fiduciaries, guardians, and so forth
    ■ A testator’s signature clause
    ■ An attestation clause, or witness clause
    ■ A self-proving clause
448   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                         12. What is a power of attorney?
                               A power of attorney is the legal document that allows the trusted person to act in one’s place.
                         13. What is a durable power of attorney for health care?
                               A durable power of attorney for health care is a specific form of a power of attorney that
                               appoints a trusted person to make health care decisions for a person who is incapacitated. It
                               eliminates the necessity of petitioning the local court to appoint a guardian ad litem or con-
                               servator if a person becomes incapacitated.
                         14. What are the definitions of the terms community property, separate property, and
                             tenancy by the entirety?
                               ■ Community property—Community property is a regime where married individuals own
                                 an equal undivided interest in all wealth accumulated during the marriage.
                               ■ Separate property—Separate property is property an individual spouse owns in its entirety
                                 (generally acquired before marriage, inherited, or received by gift).
                               ■ Tenancy by the entirety—Tenancy by the entirety is a form of JTWROS that can only
                                 occur between a husband and wife.
                         15. What are the types of property ownership interests, and how are they
                             transferred?
                               ■ Fee simple—transfers through probate
                               ■ Tenancy in common—transfers through probate
                               ■ Joint tenancy with right of survivorship (JTWROS)—passes to the surviving tenant out-
                                 side of the probate process according to state law regarding survivorship rights
                               ■ Tenancy by the entirety—passes to the surviving spouse according to the state law regard-
                                 ing tenancy by the entirety
                               ■ Community property—transfers through probate
                               ■ Pay-on-death (POD), transfer-on-death (TOD) accounts—legally transfers to the named
                                 beneficiary without going through the probate process
                         16. What are the duties of the executor/administrator of a will?
                               The duties of the executor/administrator are as follows:
                               ■ Locates and assembles property
                               ■ Safeguards, manages, and invests property
                               ■ Advertises in legal newspapers that the person has died and creditors and other interested
                                 parties are on notice
                               ■ Locates and communicates with potential beneficiaries
                               ■ Pays the expenses of the decedent's estate
                               ■ Pays the debts of the decedent
                               ■ Files federal and state tax returns, such as Forms 1040, 1041, and 706, and makes tax
                                 payments
                               ■ Distributes assets to beneficiaries according to the will or the laws of intestacy
                         17. What is a living trust?
                               A living trust is one in which the grantor creates an inter vivos trust that is funded with part
                               or all of the grantor’s property.
                                                    Chapter 17 | Introduction to Estate Planning   449


18. What is a grantor trust?
    A grantor trust is a trust in which the grantor transfers property into a trust but the grantor
    retains some right of enjoyment of the property, usually an income right. The income from
    the trust is taxed to the grantor.
19. How can the gross estate be reduced?
    The gross estate can be reduced in any of the following ways:
    ■ Appropriate use of qualified transfers
    ■ Gifts under the annual exclusion
    ■ Use of the lifetime exemption
    ■ Personal consumption
    ■ Lifetime transfers to charities
    ■ Removing the proceeds value of life insurance from the gross estate by having someone
      other than the insured as the owner of the policy.
20. What are the common estate planning mistakes?
    ■ Invalid, out-of-date, or poorly drafted wills
    ■ Simple wills (Sweetheart, or “I love you,” wills)
    ■ Improperly arranged or inadequate life insurance
    ■ Possible adverse consequences of jointly held property
    ■ Estate liquidity problems
    ■ Wrong executor/trustee/manager
21. What is the applicable credit amount, and how does it affect an individual’s
    federal estate tax liability?
    The applicable credit is a lifetime gift and estate tax credit that is used to offset the gift and
    estate tax on inter vivos and testamentary transfers. This credit allows taxpayers to transfer,
    either during life or at death, assets without incurring any transfer tax. The applicable cred-
    its for 2009 are $1,455,800 (estate tax) and $345,800 (gift tax). The applicable exclusion is
    $3.5 million (estate tax) and $1 million (gift tax).
22. How can the annual gift tax exclusion be used as an estate planning tool?
    By taking advantage of the annual gift tax exclusion, an individual can remove the gifted
    assets from his estate, potentially reducing the estate tax liability. The limit is $13,000 per
    donee per year (2009 and 2010). The $13,000 is indexed for inflation.
23. What is gift splitting?
    Gift splitting is a device used by married individuals to effectively increase the annual exclu-
    sion to $26,000 for 2009 and 2010. Because the exclusion per donee perishes annually,
    the spouse donor is essentially using the exclusion right for one particular donee, in one
    particular year, because the nondonor spouse would not have used it.
24. What are qualified transfers?
    A qualified transfer is a payment made directly to an educational institution for tuition and
    fees or a payment made directly to a medical provider for medical expenses for someone
    else’s benefit. These qualified transfers allow taxpayers to effectively transfer wealth to others
    without being subject to transfer tax.
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                         25. When is the gift tax return due?
                               The gift tax return is due April 15 but may be extended until October 15, as with individual
                               income tax returns.
                         26. What are the advantages and disadvantages of the unlimited marital deduction?

                               Advantages include the following.

                               ■ The marital deduction allows one spouse to gift or bequeath assets without tax.
                               ■ When an individual dies, he can defer the tax on his estate until his spouse dies.

                               Disadvantages include the following.

                               ■ Overqualification can occur if the first spouse to die does not take advantage of the
                                 unified credit.
                               ■ To qualify, spouses must be US citizens or else a special type of trust (QDOT) must be
                                 used, which may affect some families.
                         27. What are the steps in calculating the estate tax?
                               The steps are shown in this manual and in Exhibit 17.16 in the textbook. The student
                               should at minimum list these steps.
                         28. What are at least three estate planning techniques available to reduce gift and
                             estate taxes?
                               There are several techniques to reduce estate tax.
                               ■ Do not overqualify the estate. Use the applicable exclusion amount for each spouse.
                               ■ Do not underqualify the estate. Use an appropriate amount for the marital deduction,
                                 generally to reduce estate tax to zero.
                               ■ Generally, remove life insurance from the estate of the client.
                               ■ Change the ownership of life insurance, or use irrevocable life insurance trust (must
                                 remove all incidents of ownership).
                               ■ Use lifetime gifts. Make use of annual exclusions with gift splitting.
                               ■ Use basic trusts.
                               ■ Use charitable contributions, transfers, and trusts.
                         29. When is the estate tax return due to be filed with the IRS ?
                               The estate tax return is due nine months after the date of death with an extension of six
                               months available.
                         30. What are the applicable credit amounts against federal gift and estate taxes for
                             2009?
                               The applicable credit amount for gift taxes is $345,800 (based on the applicable exclusion of
                               $1 million). The applicable credit amount for estate taxes is $1,455,800 (based on the appli-
                               cable exclusion of $3.5 million).
                         31. On which IRS form do you file funeral expenses?
                               Funeral expenses are filed on Form 706, the estate tax return.
                                                  Chapter 17 | Introduction to Estate Planning   451


32. What is a trust, and what are the benefits of creating one?
    A trust is a legal arrangement (usually provided for under state law) in which property is
    transferred by a grantor to a trustee for the management and conservation of the property for
    the benefit of the named beneficiaries.
33. Benefits of trusts include the following.
    ■ They allow assets to pass outside of probate.
    ■ They can protect assets for mixed families.
    ■ Some trusts can reduce the gross estate.
    ■ They can control young or wasteful beneficiaries by distributing proceeds over time.
34. What are different types of trusts that can be created?
    Examples include the following:
    ■ Qualified terminable interest trust (QTIP)
    ■ Credit shelter trust
    ■ Power of appointment trust
    ■ Living trust (revocable)
    ■ Irrevocable trusts (inter vivos)
    ■ Testamentary trusts
    ■ Trust for minors
    ■ Irrevocable life insurance trust (ILIT)
35. What is the generation-skipping transfer tax?
    The generation-skipping transfer tax (GSTT) is in addition to the unified gift and estate
    tax and is designed to tax large transfers that skip a generation (i.e., from grandparent to
    grandchild). The purpose of the tax is to collect potentially lost tax dollars from the skipped
    generation.
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      EXERCISES AND SOLUTIONS

                           1. Which of the following persons need estate planning?
                                ■ Steve, who has a wife and one small child and a net worth of $350,000.
                                ■ Earl, married with nine children, six grandchildren, and a net worth of $4,000,000.
                                ■ Ellen, divorced, whose only son is severely challenged intellectually.
                                ■ Mary, who is single, has a net worth of $150,000 and has two cats that she considers her
                                  children.
                                All of these persons have a need for a will, a plan for incapacity, and a plan to care for per-
                                sons or pets.
                           2. Place the following estate planning steps in their proper order.
                                ■ Establish priorities for estate objectives.
                                ■ Prepare a written plan.
                                ■ Define problem areas including liquidity, taxes, and so forth.
                                ■ Gather client information, and establish objectives.
                                The proper order is as follows.
                                1.   Gather client information, and establish objectives.
                                2.   Define problem areas including liquidity, taxes, and so forth.
                                3.   Establish priorities for estate objectives.
                                4.   Prepare a written plan.
                           3. List and describe the arrangements that are plausible when dealing with
                              unanticipated incapacity.
                                A durable power of attorney for health care is a primary way to plan for incapacity. Another
                                choice is an inter vivos trust with a durable power of attorney for health care.
                           4. Describe why each of the following would be considered potential problems of an
                              estate plan:
                               1. Ancillary probate
                               2. A will that includes funeral instructions
                               3. A will that attempts to disinherit a spouse and/or minor children
                                ■ An ancillary probate indicates that the estate owns property outside the decedent’s state
                                  of domicile and may cause excessive costs and delays; you could have used JTWROS
                                  titling instead.
                                ■ A will that includes funeral instructions may be lost or there may be delays in proving the
                                  will, which could cause funeral instructions not to be carried out.
                                ■ A will that attempts to disinherit spouses and/or minor children should be approached
                                  with great care because such a will may be against public policy (state law) and therefore
                                  ineffective.
                                                  Chapter 17 | Introduction to Estate Planning   453


5. Describe each of the following common provisions in a well-drafted will:
  1. Establishment of the domicile of testator
  2. An appointment and powers clause
  3. A survivorship clause
  4. A residuary clause
   The provisions are described as follows.
   ■ The establishment of the domicile is important to establish in which state personal prop-
     erty should be taxable.
   ■ An appointment and powers clause is used to name fiduciaries, guardians, and so forth.
   ■ A survivorship clause provides that the beneficiary must survive the decedent for a speci-
     fied period in order to receive the inheritance or bequest. This clause prevents property
     from being included in two different estates in rapid succession.
   ■ A residuary clause is used to transfer the balance of any other assets to someone or some
     institution. Not having a residuary clause may result in remaining assets that are not
     already bequeathed to be distributed under the state intestacy laws.
6. Which of the following statements is(are) NOT correct?
   ■ A durable power of attorney for health care is always a direct substitute for a living will.
   ■ A living will only covers a narrow range of situations.
   ■ A living will must generally meet the requirements specified by state statute.
   ■ Many well-intentioned living wills have failed because of vagueness and/or ambiguities.
   The first statement is incorrect. A durable power of attorney does not always substitute for
   a living will because in many states a specific statute governs living wills, and unless the
   durable power meets that specific language, it will not be a valid living will. The other state-
   ments are correct.
7. Marleen has a general power of appointment over her mother’s assets. Which of
   the following statements regarding the power is(are) CORRECT?
  1. Marleen can appoint her mother’s money to pay for the needs of her mother.
  2. Marleen can appoint money to Marleen’s creditors.
  3. Marleen must only appoint money using an ascertainable standard (health,
     education, maintenance, and support).
  4. If Marleen were to die before her mother, Marleen’s gross estate would include
     her mother’s assets although they were not previously appointed to Marleen.

  1. Correct. Marleen can appoint her mother’s money to pay for the needs of her mother.
  2. Correct. Marleen can appoint money to Marleen’s creditors.
  3. Incorrect. Marleen can appoint money using an ascertainable standard (health, educa-
     tion, maintenance, and support) or for any other reason.
  4. Correct. If Marleen were to die before her mother, Marleen’s gross estate would include her
     mother’s assets even though they were not previously appointed to Marleen.
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                          8. Describe each of the following property ownership arrangements:
                              1. Tenancy in common
                              2. Joint tenancy with right of survivorship
                              3. Tenancy by the entirety
                              4. Community property

                              1. Tenancy in common is where two or more persons hold an undivided interest in
                                 the whole property.
                              2. Joint tenancy with right of survivorship is where two or more persons called equal
                                 owners hold the same fractional interest in a property and there is a right of sur-
                                 vivorship when one owner dies.
                              3. Tenancy by the entirety is a JTWROS that can only occur between spouses.
                              4. Community property is a regime recognized in some states where married individu-
                                 als own an equal undivided interest in all wealth accumulated during the marriage.
                          9. Which of the following statements regarding joint tenancy is(are) CORRECT?
                              1. Under a joint tenancy, each tenant has an undivided interest in the property.
                              2. Joint tenancies may only be established between spouses.
                              3. Community property is the same as joint tenancy and has been adopted in
                                 many states.
                              4. Assuming a spousal joint tenancy, the full value of the property will be includ-
                                 ed in the gross estate of the first spouse to die without regard to the contribu-
                                 tion of each spouse.
                               Only the first statement is correct. Anyone may establish a joint tenancy, which includes
                               spouses as well as nonspouses. Only half the value in a spousal joint tenancy is included in
                               the gross estate of the first spouse to die. Community property is not joint property. The
                               first spouse to die can transfer his share of community property to anyone he selects. Unlike
                               a joint tenancy, in community property there is no survivorship transfer to the surviving
                               spouse.
                         10. Generally speaking, which of the following property is included in the probate
                             estate?
                              1. Property owned outright in one’s own name at the time of death
                              2. An interest in property held as a tenant in common with others
                              3. Life insurance, and other death proceeds, payable to one’s estate at death
                              4. The decedent’s half of any community property
                               All are examples of property that passes through probate.
                         11. Describe at least 3 advantages and 3 disadvantages of the probate process.
                               Advantages:
                              1. Protects creditors.
                              2. Provides clear title to heir or legatee.
                              3. Improves the likelihood that parties in interest will receive notice and the opportunity to
                                 be heard.
                                                    Chapter 17 | Introduction to Estate Planning   455


    4. Provides for an orderly administration of decedent’s assets.
    Disadvantages:
    1. Process may be costly.
    2. Process can result in delays.
    3. Process is open to public scrutiny.
12. Identify alternatives to probate regarding disposition of property.
    1. Property held as tenants by the entirety or joint tenancy with right of survivorship
    2. Property held within a revocable living trust
    3. Property held within an irrevocable trust
    4. Proceeds of an insurance policy (second-to-die) with named beneficiary
13. John and Mary Hurley are both 36 years old with one child, Patrick, age 6.
    What documents do the Hurleys need for estate planning?
    The Hurleys each need wills, durable powers of attorney for property and health care, and
    perhaps advance medical directives (living will). A side letter may also be convenient.
14. Given Mark’s assets below, which will go through the probate process if Mark dies?

     Life insurance         Face             $100,000         Beneficiary is Mary
     IRA                    Balance          $200,000         Beneficiary is Mary
     Personal residence     Value            $280,000         Titled JTWROS with Mary
     Automobile             Value              $4,000         Owned by John

    Only the automobile will go through the probate process. The other assets pass by operation
    of law (JTWROS) or by contract with named beneficiaries.
15. Ann is married to Roy. They have no children. Given that Ann has the follow-
    ing assets, what could she do to reduce her gross estate?

                Life insurance      Face           $2,000,000        Owner is Ann
                Cash                Amount         $4,000,000        Owner is Ann

    She could transfer the insurance to an ILIT. She should also use qualified transfers, annual
    exclusion, and lifetime exemption of $3.5 million for 2009. Leaving the balance of her estate
    to Roy does not reduce the gross estate but rather the taxable estate.
16. During this year, Bob gave $100,000 to his son and $100,000 to his daughter.
    Bob’s wife, Lori, also gave $5,000 to their son. No other gifts were made during
    the year. Bob and Lori elected to split the gifts on their gift tax returns. What is
    the amount of taxable gifts made by Bob and Lori?
    Bob and Lori would both have taxable gifts of $76,500 [($205,000 – $52,000) ÷ 2].
    There are several concepts in this question that students may miss.
    ■ When gifts are split, all gifts for that year must be split.
    ■ Taxable gifts is a term meaning net of the annual exclusion.
    ■ The two donees allow for $52,000 in annual exclusion.
456   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                         17. Which of the following situations would not constitute a taxable transfer under
                             the gift tax statutes?
                              1. Frank creates an irrevocable trust under the terms of which his son is to
                                 receive income for life and his grandson the remainder at his son’s death.
                              2. Frank, with personal funds, purchases real property and has the title conveyed
                                 to himself and his brother as joint tenants with right of survivorship.
                              3. Frank creates a trust giving income for life to his wife providing that, at her
                                 death, the corpus is to be distributed to their daughter. Frank reserves the
                                 right to revoke the transfer at any time.
                               Statements 1 and 2 constitute taxable gifts. Statement 3 does not constitute a taxable trans-
                               fer because by reserving the right to revoke, the individual has not completed the gift.
                         18. Stephen created a joint bank account for himself and his friend, Anna. When is
                             there a gift to Anna?
                               There is no gift until Anna draws on the account for her own benefit.
                         19. During this year, Mark and Lydia made joint gifts of the following items to their
                             son:
                              1. A bond with an adjusted basis of $13,000 and a fair market value of $40,000
                              2. Stock with an adjusted basis of $22,000 and a fair market value of $33,000
                              3. An auto with an adjusted basis of $13,000 and a fair market value of $14,000
                              4. An interest-free loan of $6,000 for a computer (for the son’s personal use) on
                                 January 1, that was repaid by their son on December 31. Assume the appli-
                                 cable federal rate was 5% per annum
                               What is the gross amount of gifts includable in Mark and Lydia’s gift tax returns
                               for this year?
                               The gross amount of gifts included on the tax return is $87,000. The interest on the loan in
                               statement 4 is not a gift because the loan is for less than $10,000.
                         20. Tamara, who is single, gave an outright gift of $50,000 to a friend, Heather, who
                             needed the money to pay her medical expenses. In filing the gift tax return, how
                             much is Tamara entitled to exclude?
                               Tamara is entitled to exclude only $13,000 for 2009. The gift is a present interest and, there-
                               fore, qualifies for the annual exclusion. This is not a qualified transfer for medical purposes
                               because the payee is not a medical institution.
                         21. Which of the following situations constitutes a transfer that comes within the
                             gift tax statutes?
                              1. Mark creates a trust under the terms of which his son is to get income for life
                                 and his grandson the remainder at his son’s death.
                              2. Mark purchases real property and has the title conveyed to himself and to his
                                 brother as joint tenants.
                              3. Mark creates an irrevocable trust giving income for life to his wife providing
                                 that upon her death the corpus is to be distributed to his daughter.
                              4. Mark purchases a US savings bond made payable to himself and his wife. His
                                 wife surrenders the bond for cash to be used for her benefit.
                                                   Chapter 17 | Introduction to Estate Planning   457


    This question is somewhat tricky, and your students may not pick out the subtle issues. All
    of the gifts fall under the gift tax statutes because they all meet the definition of a completed
    gift. The distinction here is that they are not all subject to tax. The question asks which
    ones will fall under the statutes, and the answer will be they all will; but many students will
    assume the question is asking which are taxable. In that case, they will want to exclude
    the gift to the wife because they want to say the marital deduction excludes it from being
    taxable.
22. Which of the following situations would NOT constitute a transfer that comes
    within the gift tax statutes?
    1. Robin creates a trust under the terms of which her daughter is to get income
       for life and her granddaughter the remainder at the daughter’s death.
    2. Robbie purchases real property and has the title conveyed to himself and to
       his brother as joint tenants.
    3. Randal creates an irrevocable trust giving income for life to his wife and pro-
       viding that at her death the corpus is to be distributed to his son.
    4. Ray purchases a US savings bond made payable to himself and his wife,
       Raquel. Raquel cashes the bond to be used for her own benefit.
    5. Rose creates a joint bank account for herself and her daughter. There have
       been no withdrawals from the account.
    The last statement is the only situation that does not constitute a transfer that comes within
    the gift tax statutes. A gift does not occur until the withdrawal by the daughter for her own
    benefit. After the previous question, students may be conflicted as to why, with similar situa-
    tions of a bank account, this situation is not under the statutes but the previous example is.
    The main distinction here is that Mark’s wife actually surrendered the bond creating the
    completed gift, whereas Rose’s daughter has not made any withdrawals and therefore has not
    completed the gift.
23. Which of the following represent(s) taxable gifts?
    1. The transfer of wealth by a parent to a dependent child that represents legal
       support.
    2. Payment of a child’s tuition to Loyola’s Law School by a parent.
    3. Payment of $20,000 from a grandparent to a grandchild for educational
       purposes.
    4. Payment of $15,000 of medical bills for a friend paid directly to the medical
       institution.
    The third statement represents a taxable gift because the payment is made directly to the
    child and not the educational institution. Direct payment of tuition, medical bills paid to an
    institution, and support are not taxable gifts.
24. Victor wants to begin a program of lifetime giving to his 3 grandchildren and 5
    great-grandchildren. He wants to control the amount of annual gifts to avoid the
    imposition of federal gift tax, and he does not desire to use any of his or his wife
    Veronica’s applicable credit. Veronica is willing to split each gift over 10 years.
    What is the total amount of gifts, including gift splitting, that Victor can give over
    the 10 years? (Assume the annual exclusion for all years is the same as for 2009.)
458   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                               Using 2009 Annual Exclusion:
                               Victor can gift $2,080,000 over 10 years. The calculation is as follows:

                                                                       $13,000 per donee
                                                                             × 8 number of donees
                                                                      $104,000
                                                                            × 10 years
                                                                    $1,040,000
                                                                             × 2 spouses
                                                                    $2,080,000

                         25. Rodney and his wife, Lois, have 4 children, each over the age of majority,
                             2 grandchildren over age 21, and 6 minor grandchildren. Rodney and Lois want
                             to make gifts to their children and grandchildren sufficient to make maximum
                             use of the tax provisions providing for annual exclusions from federal gift tax.
                             Considering that desire only, what is the total amount of gifting that Rodney and
                             Lois can make during 2009?
                               They can gift $312,000 ($13,000 × 12) using the 2009 annual exclusion amount. The
                               issue of the ages of the grandchildren was added as a distractor, but it is not relevant to the
                               amount that can be gifted under the annual exclusion.
                         26. Kurt died on July 31. His assets and their fair market value at the time of his
                             death were:
                                                            Cash                              $150,000
                                                            Personal residence              $2,500,000
                                                            Life insurance on Kurt’s life   $1,500,000
                                                            Series EE bonds                   $200,000

                               Kurt had a balance on his residence mortgage of $150,000. What is the total of
                               Kurt’s gross estate?
                               Kurt’s gross estate is $4,350,000. All assets are includable in the gross estate. Liabilities are
                               irrelevant to the determination of the gross estate and have been added as a distractor to
                               ensure that the student can differentiate between the gross estate and the taxable estate.
                         27. Evelyn died on August 1 this year. What is her gross estate?
                               ■ Two years ago, Evelyn gave cash of $30,000 to her friend. No gift tax was paid
                                 on the gift.
                               ■ Evelyn held property jointly with her brother. Each paid $450,000 of the total pur-
                                 chase price of $900,000. Fair market value of the property at date of death was
                                 $2 million.
                               ■ In 2004, Evelyn purchased a life insurance policy on her own life and gave it as a gift
                                 to her sister. Evelyn retained the right to change the beneficiary. Upon Evelyn’s death,
                                 her sister received $3 million under the policy.
                               ■ In 1985, Evelyn gave her son a summer home (fair market value in 1985, $250,000).
                                 Evelyn continued to use it until her death pursuant to an understanding with her son.
                                 The fair market value at date of death was $500,000.
                                                   Chapter 17 | Introduction to Estate Planning   459


    Evelyn’s gross estate is $4,500,000 ($1 million for the property, $3 million for the insur-
    ance, $500,000 for the home). The gift to the friend is not included in the gross estate.
    The jointly held property is 50% included (the amount attributable to Evelyn). The last two
    items are included fully due to incidence of ownership and retained interest, respectively.
28. Jane died on May 2 of the current year, leaving an adjusted gross estate of
    $5 million at the date of death. Under the terms of the will, $375,000 was
    bequeathed outright to her husband. The remainder of the estate was left to her
    mother. No taxable gifts were made during her lifetime. In computing the taxable
    estate, how much should the executor claim as a marital deduction?
    The marital deduction is $375,000 (the amount bequeathed to the spouse).
29. Joshua died in 2009 with a taxable estate of $4 million. He had made no previ-
    ous taxable gifts during his lifetime. How much is his federal estate tax?
    The tax is calculated on the basis of the estate tax table. For 2009, Joshua’s estate tax will be
    $225,000 ($1,680,800 – $1,455,800).
30. Joseph died in 2009 with a taxable estate of $10 million and had previously
    given adjusted taxable gifts of $700,000. During his life, he used applicable
    gift tax credits of $64,800. What amount will Joseph subtract on his estate tax
    return for his applicable credit amount?
    Joseph will allowed to take the full credit of $1,455,800. Students may assume that the
    answer should be the current applicable credit amount minus the used credit. This approach
    is incorrect. Because of the increasing applicable credit amount, it is necessary to add back
    in the previous taxable gifts to the taxable estate to determine the current tax owed. From
    there you will subtract any gift tax paid and the current available applicable credit amount.
31. Identify at least 3 alternative methods of limiting, reducing, or avoiding federal
    estate taxes.
    Methods include the following:
    ■ Use of the annual gift tax exclusion ($13,000 for 2009)
    ■ Creation of an irrevocable life insurance trust
    ■ Use of gift tax exclusions for tuition and medical expenses payments made directly to the
      provider
    ■ Use of the unlimited marital deduction
32. Which of the following transfers qualify for the unlimited marital deduction?
    1. Outright bequest to resident alien spouse
    2. Property passing to citizen spouse in QTIP
    3. Income beneficiary of CRT is a nonresident alien spouse (trust is not a
       QDOT)
    4. Outright bequest to resident spouse who, prior to the decedent’s death, was
       a noncitizen but who, after the decedent’s death and before the estate return
       was filed, became a US citizen
    The second and fourth statements qualify for the marital deduction. If the spouse is a non-
    resident, noncitizen, a QDOT must be used to qualify for the marital deduction.
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                         33. Who among the following would be skip persons for purposes of the GSTT?
                             Matt, the transferor, is 82 years old.
                               ■ Tim, the grandson, of Matt whose mother, Bonnie, is living but whose father, Ben,
                                 son of Matt, is deceased
                               ■ Mindy is the great-grandchild of Matt. Both Mindy’s parents and grandparents are
                                 living)
                               ■ Sharon is the 21-year-old wife of Matt’s second son, age 65
                               Students should have analyzed this question as follows
                               ■ Tim is not a skip person because of the predeceased parent rule. He will effectively move
                                 up into the father’s place.
                               ■ Mindy is obviously a skip person.
                               ■ Sharon is not a skip person because she has married into a nonskip generation.
                         34. Rosalie, who is single, is diagnosed with a serious disease and expects to be com-
                             pletely incapacitated in three years. Rosalie has two daughters and two grandchil-
                             dren. She has $500,000 in net worth including her principal residence. Which
                             of the following estate planning tools would you recommend for Rosalie?
                               ■ Set up a durable power of attorney.
                               ■ Immediately gift annual exclusion amounts to children and grandchildren.
                               ■ Set up a revocable living trust.
                               ■ Set up an irrevocable living trust.
                               ■ Set up a QTIP trust.
                               Recommendations are as follows.
                               ■ Yes. She should set up a power of attorney to allow someone to manage her affairs for her
                                 because she is near incapacitation.
                               ■ No. She does not have enough assets at this point to face any estate tax consequences,
                                 and she may need the money during her illness.
                               ■ Yes. She can set up a living trust now, but she should keep it revocable in case she needs
                                 the money.
                               ■ No. She will not want to lose access to the money at this time.
                               ■ No. She is not married.
                         35. On April 30, Dennis transfers property to a trust over which he retains a right
                             to revoke one-fourth of the trust. The trust is to pay Kim 5% of the trust assets
                             valued annually for her life, with the remainder to be paid to a qualified charity.
                             On August 31, Dennis dies and the trust becomes irrevocable. Identify the type
                             of trust.
                               This is a grantor trust. Because of the revocable feature, it is not a charitable remainder trust.
                                                          Chapter 17 | Introduction to Estate Planning   461




PROBLEMS AND SOLUTIONS

        1. Kristi and Patrick Moore are 35 years old with two children, Christopher (age 4)
           and Andrew (age 2). The Moores have simple wills that leave everything to each
           other. They have asked you to help them update their will. What would you
           recommend?
           The student should discuss several of the clauses that are listed in the chapter as ways to
           improve the Moores’ wills. Examples would include the following.
           ■ The Moores should have simultaneous death clauses, or survivorship clauses, in their wills
             in case they are killed together.
           ■ The Moores should definitely have a guardianship clause to name a guardian for their
             children.
           ■ The Moores may want to add a side letter to discuss funeral arrangements and to address
             specific personal property bequests.
           The student may also discuss the use of a power of attorney for property, a power of attorney
           for health care, and a living will as additions to the Moores’ updated will.
        2. Tomas is a wealthy golfer who would prefer that his assets not be subject to
           public scrutiny when he dies. What tools can he use to accomplish his goal?
           Tomas’s main plan of action would be to keep all of his property out of probate to accom-
           plish his goal. He can use several different methods to ensure that his property passes via
           contract or operation of law to avoid probate. Examples include the following.
           ■ Place all property in a trust.
           ■ Retitle property so it is owned with a survivorship feature and will pass via the operation
             of law.
           ■ Use items such as annuities, PODs, and TODs to pass property by contract.
        3. George owns the following property:
          1. Boat (fee simple)
          2. Condominium on the beach (tenancy in common with his brother and sister)
          3. House and two cars with his wife, Ann (tenancy by the entirety)
          4. Checking account with his son, Bill (POD)
          5. Karate business (JTWROS with his partner, Eric)
           Which items will go through probate? Which property ownership could he sell
           without the consent of a co-owner?
           The following items will go through probate:
           ■ Boat
           ■ Condominium on the beach
           The following items can be sold:
           ■ Boat
           ■ Condominium on the beach
462   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                               ■ Karate business
                               ■ George’s interest in the house and two cars may be sold but only with Ann’s consent.
                                 George may dispose or sever his interest in the other properties without the consent of
                                 any existing co-owners.
                          4. Neal is a widower with a taxable estate of $6 million. He has made no taxable
                             lifetime gifts. What is his federal estate tax due before the applicable credit if
                             Neal dies in 2009? What is the amount of the applicable credit?
                               For 2009, Neal’s estate tax is $1,125,000. The tentative tax due is calculated as follows:
                               [($6,000,000 – $1,500,000) × 45%] + $555,800 =
                               ($4,500,000 × 45%) + $555,800 =
                               $2,025,000 + $555,800 = $2,580,800
                               The estate credit will be offset against the tax, leaving estate tax due of $1,125,000
                               ($2,580,800 – $1,455,800).
                          5. Denise and Barry are married and own total assets with a fair market value of $8
                             million, all of which are in Barry’s name alone. Barry leaves his entire estate to
                             Denise, and Denise leaves her entire estate to their children. Assume Barry dies
                             in January 2009 and Denise dies in November 2009. What is the total amount
                             of federal estate tax that will be paid on the two estates? (Assume the fair market
                             value of the estate is unchanged when Denise dies.)
                               There is no federal estate tax due when Barry dies because his entire estate qualifies for the
                               marital deduction. When Denise dies the marital deduction is not available, and the estate
                               tax payable will be $2,025,000 ($3,480,800 – $1,455,800).
                          6. In 2009, Georgia gave a $10,000 cash gift to her friend, Mary. How much is the
                             taxable gift?
                               There is no taxable gift because the amount is within the annual exclusion. For 2009,
                               Georgia would be able to gift $13,000 to Mary without gift tax consequences.
                          7. For each of the past 10 years, Jessica has given $14,000 to each of her 6 grand-
                             children and $25,000 each to her son and daughter. What is the total amount
                             of taxable gifts? (Assume the annual exclusion for all 10 years is the same as for
                             2009.)
                               Jessica’s taxable gifts are calculated as follows:

                                       Grandchildren              Children
                                                  $14,000             $25,000 Amount gifted
                                                       ×6                  × 2 Total recipients
                                                  $84,000             $50,000
                                                      × 10                × 10 Number of years

                                                $840,000            $500,000
                                                                  $1,340,000 Total gifts to children and grandchildren
                                                                  $1,040,000 Less annual exclusions (8 × 10 × $13,000)
                                                                    $300,000 Taxable gifts
                                               Chapter 17 | Introduction to Estate Planning   463


8. Ken and Libby have the following assets:
   ■ $800,000 house in Ken’s name
   ■ $1,100,000 investment account in Libby’s name
   ■ $600,000 in rental property jointly owned with JTWROS
   ■ $300,000 beach condo that Libby co-owns with her sister as tenants in
     common
   They have 2 adult children and have made no previous taxable gifts. How much
   can they transfer today to the children free of all transfer tax in a lifetime trans-
   fer in 2009?
   For 2009:
   Ken and Libby can transfer $2,052,000.

                                     Ken                Libby
                                   $800,000         $1,100,000
                                   $300,000           $300,000
                                                      $150,000
                                 $2,650,000 total assets owned

   Libby and Ken split gift tax applicable exclusion amounts and the annual exclusion amounts
   (1,000,000 × 2) + ($26,000 × 2) = $2,052,000.
9. Charles is an 85-year-old widower with 2 sons and a daughter, 3 grandchildren,
   and a 27-year-old girlfriend. He has an estate currently worth $650,000, includ-
   ing a house worth $300,000. His estate also includes a life insurance policy
   on his life with a face value of $120,000, and the primary beneficiaries are his
   children. Charles was recently diagnosed with Alzheimer’s disease. The doctors
   predict a rapid progression and recommend that Charles go into a nursing home
   soon. He currently has a will that leaves all of his assets equally to his children.
   He has not taken advantage of any other estate planning techniques. Which of
   the following would you recommend to Charles while he still has all his mental
   faculties, and why?
  1. Create a living will, a general power of attorney, and a power of attorney for
     health care.
  2. Transfer ownership of his residence to his children so it will not be counted as
     a resource for Medicaid purposes when he goes into the nursing home.
  3. Create an irrevocable trust containing all of his assets and naming his children
     as beneficiaries.
  4. Create a revocable trust containing all of his assets and naming his children as
     beneficiaries.
  5. Create a QTIP trust naming his girlfriend as the income beneficiary and his
     children as the remaindermen beneficiaries.
464   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                               Discussion of each option follows:
                               ■ Statement 1 is appropriate. Because of his declining health, it would be in Charles’s best
                                 interest to clarify all of his wishes. Also, he will soon be unable to make certain decisions
                                 on his own behalf. By nominating his attorney in fact, he will prevent delays in his treat-
                                 ment and care that would arise in a court appointed situation.
                               ■ Statement 2 is not appropriate. It will not accomplish what is intended and may cause
                                 serious problems. He will be at risk that the children may evict him.
                               ■ Statement 3 is inappropriate due to irrevocability. By transferring all of his assets to the
                                 irrevocable trust, he will not have access to any of the assets. Therefore, he will not have
                                 the money to pay for his long-term care. His children will be forced to pay, or he will
                                 have less than adequate care. It would not be smart to tie up his assets in this fashion.
                               ■ Statement 4 may be appropriate if he gives a durable power of attorney to the successor
                                 trustee of his revocable trust, assuming he is the initial trustee. On the basis of the circum-
                                 stances, even a revocable trust would not be in his best interest because he is close to inca-
                                 pacitation. He will soon not have the mental capacity to revoke the trust, therefore tying
                                 up the assets. If he does have a power of attorney, his attorney in fact will have the ability
                                 to revoke for him, but this may cause some undesirable control over all of his assets.
                               ■ Statement 5 is inappropriate. The QTIP trust is designed for a married couple to take
                                 advantage of the marital deduction while controlling the eventual disposition of the
                                 asset. Because Charles is not married, the QTIP trust is not an appropriate device.
                                                              Chapter 17 | Introduction to Estate Planning   465



❚ ❚ CASE SCENARIO AND SOLUTIONS
               Use the information provided to answer the following questions regarding the Nelson
            family.
                                             Nelson Family Case Scenario
                                               David and Dana Nelson
                                                   as of 1/1/ 2010

            Personal Background and Information
                 David Nelson (age 37) is a bank vice president. He has been employed there for 12 years
                 and has an annual salary of $70,000. Dana Nelson (age 37) is a full-time homemaker. David
                 and Dana have been married for 8 years. They have 2 children, John (age 6) and Gabrielle
                 (age 3), and are expecting their third child in 2 weeks. They have always lived in this com-
                 munity and expect to remain indefinitely in their current residence.


            General Goals (Not Prioritized)
            ■❚   Save for college education
            ■❚   Reduce debt
            ■❚   Save for retirement
            ■❚   Estate planning
            ■❚   Invest wisely


            Insurance Information
            Health Insurance
                 The entire family is insured under David’s employer’s health plan (PPO). The plan has
            no co-payment for preventive care, a $10 co-payment for primary care, a $30 co-payment
            for specialist visits, and a $100 emergency room co-payment. The ER co-payment is waived
            if an insured is subsequently admitted to the hospital. For other covered expenses, a $0
            in-network deductible and a $500 out-of-network deductible apply, after which 80%/20%
            coinsurance applies in network and 60%/40% applies out of network. There is a stop-loss
            limit of $20,000 annually in network and $30,000 out of network annually. The plan has
            an overall lifetime maximum of $2,000,000 per family member, and the entire monthly
            premium of $1,123.54 is paid by David’s employer.


            Life Insurance
                David’s employer provides group term life insurance equal to two times his current
            salary. The premium is paid entirely by his employer, and Dana is the primary beneficiary.
            No contingent beneficiary is named.
466   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                          Disability Insurance
                              David’s employer also offers a contributory group long-term disability insurance
                          program toward which the employer contributes 60% of the $291.67 monthly premium.
                          David is a participant in the program, which provides a monthly disability income benefit
                          equal to 70% of his current salary, payable to his age 65, provided that he remains disabled
                          per the policy’s “own occupation” definition of disability. David must satisfy a 90-day
                          elimination period before he is eligible to begin receiving benefits.
                              David’s employer doesn’t offer dental or vision coverages, and the Nelsons have not
                          obtained any form of individual dental or vision insurance benefits.


                          Homeowners Insurance
                             The Nelsons have an HO-3 policy with replacement cost on contents. There is a
                          $250 deductible. The annual premium is $950.


                          Automobile Insurance
                               The Nelsons have automobile liability and bodily injury coverage of $100,000/
                          $300,000/$100,000. They have both comprehensive coverage and collision. The deduct-
                          ibles are $250 (comprehensive) and $500 (collision). The annual premium is $900.


                          Investment Information
                              The bank offers a 401(k) plan in which David is an active participant. The bank
                          matches contributions dollar for dollar up to 3% of David’s salary. David currently con-
                          tributes 5.43% of his salary. His employer’s plan allows for employee contributions of up
                          to 16%. In the 401(k), the Nelsons have the opportunity to invest in a money market
                          fund, a bond fund, a growth and income fund, and a small-cap fund. The Nelsons consider
                          themselves to have a moderate investment risk tolerance.


                          Income Tax Information
                              David and Dana tell you that they are in the 15% federal income tax bracket. They
                          pay $820 annually in state and local income taxes.


                          Education Information
                               John is 6 years old and currently attending first grade at a private school. Gabrielle
                          is 3 years old. She will attend private school from prekindergarten through high school.
                          The current balance of the college fund is $14,000. They expect to contribute $1,000 at
                          the end of each year to this fund.


                          Gifts, Estates, Trusts, and Will Information
                              David has made Dana his primary beneficiary on his 401(k), and the children are the
                          contingent beneficiaries. Because most of their assets are owned jointly, David doesn’t see
                          the need for a will. Dana also does not have a will.
                                                       Chapter 17 | Introduction to Estate Planning       467


     Relevant External Environmental Information
     ■❚   Mortgage rates are 6.0% for 30 years and 5.5% for 15 years, fixed.
     ■❚   Gross domestic product is expected to grow at less than 3%.
     ■❚   Inflation is expected to be 2.6%.
     ■❚   Expected return on investment is 10.4% for common stocks, 12.1% for small com-
          pany stocks and 1.1% for US Treasury bills.
     ■❚   College education costs are $15,000 per year.

                                        Dana and David Nelson
                                    Statement of Financial Position
                                             12/31/2009
Assets                                     Liabilities and Net Worth
Cash/Cash Equivalents                      Current Liabilities
JT        Checking Account        $1,268   JT             Credit Cards                                 $3,655
JT        Savings Account          $950    JT             Mortgage on Principal Residence              $1,370
Total Cash/Cash                   $2,218   H              Boat Loan                                    $1,048
Equivalents
                                           Total Current Liabilities                                   $6,073
Invested Assets                            Long-Term Liabilities
W         ABC Stock              $14,050   JT             Mortgage on Principal Residence        $195,284
JT        Educational Fund       $15,560   H              Boat Loan                                   $16,017
H         401(k)                 $38,619   Total Long-Term Liabilities                           $211,301
H         XYZ Stock              $10,000
Total Invested Assets            $78,229
Personal-Use Assets                        Total Liabilities                                     $217,374
JT        Principal Residence   $250,000
JT        Automobile             $15,000
H         Personal watercraft    $10,000   Net Worth                                             $241,573
H         Boat B                 $30,000
W         Jewelry                $13,500
JT        Furniture/             $60,000
          Household
Total Personal-Use Assets       $378,500   Total Liabilities and Net Worth                       $458,947

Total Assets                    $458,947

H = husband; W = wife; JT = joint tenancy


          Notes to Financial Statements:
     ■❚   Assets are stated at fair market value.
     ■❚   The ABC stock was inherited from Dana’s aunt on November 15, 2002. Her aunt
          originally paid $20,000 for it on October 31, 2002. The fair market value at the
          aunt’s death was $12,000.
     ■❚   Liabilities are stated at principal only.
468   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition



                                                                    Dana and David Nelson
                                                               Personal Statement of Cash Flows
                                                                       For the year 2009
                                     INCOME
                                     Salary—David                                                  $70,000
                                     Investment Income
                                     Interest Income                                        $900
                                     Dividend Income                                        $150    $1,050
                                     Total Inflow                                                  $71,050
                                     Savings
                                     Reinvestment (Interest/Dividends)                    $1,050
                                     401(k) Deferrals                                     $3,803
                                     Educational Fund                                     $1,000
                                     Total Savings                                                  $5,853
                                     Available for Expenses                                        $65,197
                                     EXPENSES
                                     Ordinary Living Expenses
                                     Food                                                 $6,000
                                     Clothing                                             $3,600
                                     Child Care                                             $600
                                     Entertainment                                        $1,814
                                     Utilities                                            $3,600
                                     Auto Maintenance                                     $2,000
                                     Church                                               $3,500
                                     Total Ordinary Living Expenses                                $21,114
                                     Debt Payments
                                     Credit Card Payments Principal                         $345
                                     Credit Card Payments Interest                          $615
                                     Mortgage Payment Principal                           $1,234
                                     Mortgage Payment Interest                           $20,720
                                     Boat Loan Principal                                  $1,493
                                     Boat Loan Interest                                   $1,547
                                     Total Debt Payments                                           $25,954
                                     Insurance Premiums
                                     Automobile Insurance Premiums                          $900
                                     Disability Insurance Premiums                          $761
                                     Homeowners Insurance Premiums                          $950
                                     Total Insurance Premiums                                       $2,611
                                     Tuition and Education Expenses                                 $1,000
                                     Taxes
                                     Federal Income Tax (W/H)                             $7,500
                                     State (and City) Income Tax                            $820
                                     FICA                                                 $5,355
                                     Property Tax (Principal Residence)                   $1,000
                                     Total Taxes                                                   $14,675
                                     Total Expenses                                                $65,354
                                     Discretionary Cash Flow (Negative)                             ($157)
                                                 Chapter 17 | Introduction to Estate Planning   469


1. Given David’s current attitudes about the necessity for a will for himself and
   Dana, what problems has David created should he or Dana die today?
    Although the assets jointly titled will pass to Dana without probate, the XYZ stock,
personal watercraft, and boat will pass to beneficiaries according to the laws of intestacy
of the state in which the Nelsons live. These beneficiaries may not be in the order David
would wish or in the amounts that he believes. Depending on the state, Dana may only
get a life estate in these assets, which would belong to the children as remainderman.
    The costs of administering an estate of someone who had died intestate can be more
than that of someone who is testate, decreasing amounts available to the beneficiaries.
    If David and Dana die simultaneously, no guardian has been named for the minor
children and no provision has been made for their long-term care or the use of their assets
to care for the children.
    With no living wills or springing durable powers of attorney, matters of health care,
end-of-life decisions, and administration of property during severe disability or illness are
made more difficult to handle and may not happen in the way the Nelsons wish or be
accomplished by the person the Nelsons trust.
2. What provisions should David have in his will?
     Some of the items that should be in the will are:
     David should provide for disposition of his solely owned assets. He should also address the
possibility of Dana predeceasing him or a simultaneous death and address the care and guard-
ianship of the children while they are minors. He should provide for the establishment of a
testamentary trust for the minor children and change the contingent beneficiary of the 401(k)
from the children to the trust. The trustee should be given limited powers to distribute amounts
for the health, education, maintenance and support of the children. The trustee should not be
the same as the children’s guardian. He should have a residuary clause that provides for transfer
of assets not specifically addressed in the will. He needs to provide for how the debts and taxes
will be paid on the estate. He should also provide a side instruction letter.
3. What basic documents and provisions should Dana have in her will?
    Dana should have a will that makes the same assumptions that David’s makes. She
has assets that are separate property, and David could predecease her or they could die
simultaneously. Their issues are the same.
4. Assume that David and Dana have implemented recommendations for debt
   repayment to increase their discretionary cash available and have increased life
   insurance coverage on David to a total of $450,000. The disability coverage has
   been changed to add coverage for illness as well as accident. As their financial
   planner, what other insurance coverages should you recommend to the Nelsons?
     The Nelsons have underestimated the impact Dana’s death would have on the fam-
ily finances. Child care and housekeeping services needed by the family in the event of
Dana’s death while the children are minors could become a major financial burden that
life insurance could help cover. The Nelsons could create an ILIT to own the insurance
policies on both of them, using the annual exclusion to provide the ILIT the funds to pay
the premiums on the policies. This would keep the policies out of the gross estate. While
the children are minors, the contingent beneficiary should be the testamentary trust cre-
ated to take care of the children. The trustee of the ILIT could be given the power to
change the beneficiary from a trust that cares for the minor children to the children as
adults once the children reach an age predetermined by the terms of the ILIT. An ILIT
would only be useful if their net worth substantially increased in future years.
478    Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition




      DISCUSSION QUESTIONS AND SOLUTIONS

                           1. What are the primary differences in services provided by accounting firms and
                              law firms?
                                Most accounting firms provide tax, retirement, and estate planning services in addition
                                to accounting and auditing services. Most law firms provide only tax and estate planning
                                services.
                           2. Generally, which types of financial planning firms specialize in investment
                              planning?
                                Generally, insurance companies, PFP firms, brokerage houses, mutual fund firms, and banks
                                provide investment-planning services. However, as competition increases, it is likely more
                                institutions will expand to provide investment planning services.
                           3. Generally, which types of financial planning firms specialize in estate planning?
                                Generally, accounting firms, law firms, insurance companies, PFP firms, banks, and broker-
                                age houses provide estate planning services. However, as competition increases, more insti-
                                tutions will expand to provide estate planning services.
                           4. How is the Internet changing the financial planning industry?
                                The Internet is creating more competition because it is easier to reach a large number of
                                people inexpensively. Therefore, it is making financial planning more accessible to a greater
                                number of individuals, but less personal.
                           5. Which is the most recognized and respected financial planning designation?
                                CFP® certification is the most recognized and respected designation in the financial plan-
                                ning industry.
                           6. What are the primary differences between the CFP® certification and the CFA®
                              charter?
                                CFP® certification is awarded by CFP Board. The CFA® charter is awarded by The CFA
                                Institute. CFP® certification requires the passing of a one-time exam. The CFA charter
                                requires the passing of three exams. Candidates for CFP® certification study personal finan-
                                cial planning, including insurance, investments, taxation, retirement plans, and estate plan-
                                ning. Candidates for the CFA charter study financial analysis and investment principles,
                                including accounting, portfolio management, asset valuation, and securities analysis.
                           7. Describe the fee-only compensation method.
                                Fee-only planners typically charge an hourly rate for advice or a fixed fee for a defined
                                engagement. Generally, they do not receive commissions.
                           8. What is the most important strategic decision that must be made when develop-
                              ing a financial planning practice?
                                Choosing a market niche is the most important strategic decision a professional can make
                                regarding the development of a long-lasting, viable practice.
                           9. What can the planner do to improve the planner-client relationship?
                                Regular contact and effective communication help to develop the personal relationships
                                that are essential in maintaining clients. Effective communication skills include being a
                                good listener and demonstrating respect for the client.
                                                                    Chapter 19 | Ethical Responsibilities   491




DISCUSSION QUESTIONS AND SOLUTIONS

        1. Compare and contrast ethics, law, and an ethics code.
           Ethics is the discipline of dealing with the moral principles or values that guide one’s
           self. Law is defined as rules of conduct that are established by government that command
           and encourage behavior considered right and prohibit behavior considered wrong. Law
           and ethics differ in that laws apply to everyone, under certain authority, and compliance
           with law is mandatory. Unlike law, a violation of or deviation from one’s ethics does not
           necessarily subject that person to punishment. A code of ethics is a set of principles of
           conduct that governs a group of individuals and usually requires conformity to professional
           standards of conduct.
        2. What is the Certified Financial Planner Board of Standards, Inc.?
           The Certified Financial Planner Board of Standards, Inc. (CFP Board) is an independent
           professional regulatory organization that owns the federally registered CFP® and CERTIFIED
           FINANCIAL PLANNER™ marks. The CFP Board regulates financial planners through
           trademark law by certifying individuals who meet its certification requirements to use these
           federally registered marks.
        3. What is the role of the CFP Board's Standards of Professional Conduct?
           The Standards of Professional Conduct provide the ethical rules that apply to everyone who
           has been certified to use the CFP® marks, as well as those who seek certification. They also
           specify the disciplinary process that will be used to investigate and punish violations. They
           do not define standards of professional conduct for purposes of civil liability.
        4. What is the role of the Rules of Conduct in relation to the CFP Board’s
           Standards of Professional Conduct?
           The Rules of Conduct establish the high standards expected of certificants. They are binding
           on all certificants who have the right to use the CFP® marks, regardless of their title, type
           of employment, or method of compensation, and regardless of whether they use actually use
           the CFP® marks or not. Violations may subject a certificant or registrant to discipline.
           The Rules of Conduct cover several distinct areas of responsibility, including a certificant’s
           duties with respect to client information and property, a certificant’s duties with respect to
           his employer, and a certificant’s duties with respect to CFP Board.
        5. What are a CFP® certificant’s responsibilities with respect to client property?
           First of all, if a certificant will take custody, exercise investment discretion, or exercise super­
           vision over any of the client’s property, the certificant must clearly identify and keep com­
           plete records of that property. A certificant must also take steps to secure any client property
           that is within the certificant’s control.
           A certificant must return a client’s property upon request or as soon as practicable or con­
           sistent with a time frame specified in the client agreement. The client’s property includes
           any personal records and documents the client provided to the certificant in connection
           with the financial planning services. Procrastination or outright refusal to return the cli­
           ent’s original records is unprofessional and inappropriate. A certificant may feel reluctant
           to return a client’s original records and property if the client has not paid the certificant for
           his services, but this is not acceptable—a certificant must return the client’s original records
           promptly upon request even if he has not been paid. Note that when the certificant has not
           been paid, however, the financial plan developed and drafted by the certificant is not the
           client’s property.
492   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                           6. What is the role of the Disciplinary Rules and Procedures in relation to the
                              Standards of Professional Conduct?
                               Violations of the Standards of Professional Conduct may result in a letter of admonition,
                               private censure, suspension, or revocation of the right to use the CFP® marks. These forms of
                               discipline are established in the Disciplinary Rules and Procedures. The enforcement of the
                               Standards of Professional Conduct is accomplished through CFP Board’s Disciplinary Rules
                               and Procedures.
                           7. What restrictions apply to loans between CFP® certificants and their clients?
                               Loans between certificants and their clients are allowed only in a few specified circumstanc­
                               es. A certificant is allowed to borrow money from a client only if:
                               ■ the client is a member of the certificant’s immediate family, or
                               ■ the client is an institution in the business of lending money and the borrowing is not
                                 related to the certificant’s professional services. This exception means that a certificant
                                 who performs financial planning services for a bank, for example, is allowed to take out a
                                 loan at the bank if the loan is not related to the certificant’s professional services.
                               Similar restrictions apply to loans from a certificant to a client. A certificant may lend
                               money to a client only if the client is a member of the certificant’s immediate family or the
                               certificant is an employee of an institution in the business of lending money and the money
                               lent is the institution’s and not the certificant’s.
                           8. What are the seven principles provided by the Code of Ethics and Professional
                              Responsibility?
                               The seven principles are as follows:
                               ■ Integrity
                               ■ Objectivity
                               ■ Competence
                               ■ Fairness
                               ■ Confidentiality
                               ■ Professionalism
                               ■ Diligence
                           9. Explain the term commingling and the restrictions on commingling that apply to
                              CFP® certificants.
                               The term commingling describes the act of mixing property (usually funds) belonging to one
                               party with property belong to someone else. For example, commingling occurs when a plan­
                               ner deposits client funds into his personal bank account.
                               A certificant may not commingle a client’s property with the certificant’s property unless
                               doing so is permitted by law or is explicitly authorized in a written agreement between the
                               parties. Likewise, a certificant may not commingle a client’s property with other clients’
                               property unless doing so is authorized by law or the certificant has written authorization
                               from each client and sufficient record­keeping to track the assets accurately.
                               The restrictions on commingling represent one aspect of the fiduciary relationship that
                               exists between certificants and their clients. Certificants act as fiduciaries in handling their
                               clients’ money, so they are obligated to act solely in the best interest of their clients. They
                               are not allowed to benefit personally from the property or money they are managing for
                               others.
                                                           Chapter 19 | Ethical Responsibilities   493


    The prohibitions against commingling apply regardless of whether a certificant has any
    negative intent. Even when a certificant has no bad intent, commingling client funds with
    personal funds may give rise to an appearance of impropriety.
10. How do the three distinct standards, or burdens, of proof affect the treatment of
    a CFP® certificant at various stages of disciplinary proceedings?
    The three distinct burdens of proof are as follows: (1) preponderance of the evidence,
    (2) clear and convincing evidence, and (3) evidence beyond a reasonable doubt.
    ■ “Preponderance of the evidence” means that the evidence as a whole tends to prove that
      the existence of a fact is more likely than not. Generally, proof of misconduct by a certifi­
      cant must be established by a preponderance of the evidence.
    ■ Clear and convincing evidence requires more proof or more certainty in the eyes of the
      fact finder than a preponderance of the evidence; it is the measure or degree of proof that
      will produce in the mind of the fact finder a firm belief or conviction as to allegations
      sought to be established. Under the Procedures, a certificant who has been suspended for
      over a year must clearly and convincingly prove that he is worthy of reinstatement.
    ■ “Beyond a reasonable doubt” in evidence means that the fact finder is fully satisfied,
      entirely convinced, and satisfied to a moral certainty that a fact has been established.
      This standard of proof comes into play in the Procedures under Article 11.1 where a cer­
      tificant who has been convicted of a crime is subject to discipline, and the conviction is
      conclusive proof of the commission of the crime. In criminal proceedings, the burden of
      proof is beyond a reasonable doubt.
11. What four forms of discipline can be applied by the Disciplinary and Ethics
    Commission?
    If grounds for discipline are established, the Disciplinary and Ethics Commission has discre­
    tion to use any of the following forms of discipline: (1) private censure—an unpublished
    written reproach that is mailed to the censured certificant by the Disciplinary and Ethics
    Commission, (2) public letter of admonition—a publishable written reproach of the certifi­
    cant’s behavior that will normally be published in a press release or other form of publicity,
    (3) suspension (not to exceed five years), and (4) revocation—the Disciplinary and Ethics
    Commission may order permanent revocation of a certificant’s right to use the marks.
12. What are the Candidate Fitness Standards? List the conduct that will always bar
    an individual from becoming certified.
    The Disciplinary and Ethics Commission recommended and CFP Board recently approved
    specific character and fitness standards for candidates for certification to ensure an individ­
    ual’s conduct does not reflect adversely on his fitness as a candidate for CFP® certification,
    upon the profession as a whole, or upon the CFP® certification marks. These standards are
    referred to as The Candidate Fitness Standards.
    The following conduct is unacceptable and will always bar an individual from becoming
    certified:
    ■ Felony conviction for theft, embezzlement, or other financially based crimes
    ■ Felony conviction for tax fraud or other tax­related crimes
    ■ Revocation of a financial (registered securities representative, broker/dealer, insurance,
      accountant, investment advisor, or financial planner) professional license, unless the
      revocation is administrative in nature (such as not paying required renewal fees)
    ■ Felony conviction for murder or rape
494   Personal Financial Planning Theory and Practice Instructor Manual, 6th Edition


                               ■ Felony conviction for any other violent crime within the last five years
                               ■ Two or more personal or business bankruptcies
                         13. Describe the process of an individual petitioning the CFP Board for recon-
                             sideration under the Candidate Fitness Standards. What decisions might
                             the Disciplinary and Ethics Commission make regarding a petition for
                             reconsideration?
                               Individuals who have a transgression that falls under the “presumption” list must petition
                               CFP Board for reconsideration and a determination whether their conduct will bar certifica­
                               tion. The basic process for these reviews is as follows.
                               ■ The individual must submit a written Petition for Reconsideration to the Disciplinary
                                 and Ethics Commission staff.
                               ■ The individual must sign a form agreeing to CFP Board’s jurisdiction to consider the
                                 matter.
                               ■ The individual must pay a reconsideration request fee.
                               ■ Staff will review the request to ensure that the transgression falls within the “presump­
                                 tion” list:
                                  — if the transgression does not fall within the “presumption” list (meaning it falls in the
                                    “always bar” list), then staff will notify the individual accordingly, or
                                  — if the transgression falls within the “presumption” list, staff will request all relevant
                                    documentation from the individual.
                               ■ The individual may request a hearing or submit the matter upon the written petition
                                 without a hearing.
                               ■ All of the relevant information will be provided to CFP Board for a determination at
                                 regularly scheduled hearings.
                               The Disciplinary and Ethics Commission may make one of the following decisions regarding
                               a petition for reconsideration:
                               ■ Grant the petition after determining that the conduct does not reflect adversely on the
                                 individual’s fitness as a candidate for CFP® certification or upon the profession or the
                                 CFP® certification marks, and certification should be permitted
                               ■ Deny the petition after determining that the conduct reflects adversely on the indi­
                                 vidual’s fitness as a candidate for CFP® certification or upon the profession or the CFP®
                                 certification marks, and certification should be barred