Business Succession Planning Buy-Sell Agreements

Summary:

A buy-sell agreement is a legally binding contract in which the owners of a business set forth the terms and conditions of a future sale or buy back of a departing owner’s share of the business. Specifically, buy-sells control when owners can sell their interests, who can buy an owner’s interest, and at what price.

Buy-sells can accomplish many objectives, but are primarily used to ensure the smooth continuation of a business after a potentially disruptive event, such as an owner’s retirement, incapacity, or death.

Also valuable estate planning tools, buy-sells can provide for the orderly succession of a family business, and for the liquidity needed for payment of a deceased owner’s estate settlement costs and taxes. Further, if structured properly, a buy-sell can establish the purchase price as the taxable value of an owner’s business interest, avoiding unexpected estate tax consequences at the owner’s death.

What is a buy-sell agreement?

Buy-sell agreements are very important planning tools that can accomplish many things for a business with two or more owners. Sometimes referred to as a prenuptial or premarital agreement among business owners, a business continuation agreement, a stock purchase agreement, or a buyout agreement, a buy-sell is a legally binding contract that establishes when, to whom, and at what price an owner, partner, or shareholder can sell his or her interest in a business.

A typical buy-sell allows a business entity or other business owners the opportunity to purchase a departing owner’s business interest at a predetermined price. This allows the business and the remaining owners to protect themselves from future adverse consequences, such as disruption of operations, entity dissolution, or business liquidation that might result if certain events, such as an owner’s sudden incapacity or death should occur. This can also minimize the possibility that the business will fall into the hands of outsiders.

The ability to fix the purchase price as the taxable value of a business interest makes this tool especially useful in estate planning. Agreeing to a purchase price while all parties are alive minimizes the possibility of unfair treatment to a deceased owner’s heirs. And, the IRS’ acceptance of this price as the taxable value can help minimize estate taxes on the deceased owner’s business interest.

Additionally, because funding for buy-sells is typically arranged when the buy-sell is executed, the possibility that funds will not be available when needed is minimized, and a deceased owner’s estate can be provided with needed liquidity for expenses and taxes.

Tip: Buy-sells are also used to give a business and co-owners the right to buyout an owner (force an unwilling owner to sell), or to give an owner the right to force the business or co-owners to buy him or her out.

How does a buy-sell agreement work?

A buy-sell can be a separate agreement or can be created by including buy-sell provisions in a business’ operating agreement.

A buy-sell must clearly identify the potential buyers, any restrictions and limitations, and the conditions under which a sale will occur. Sale triggering events typically include:

• Death
• Long-term disability
• Retirement
• Divorce
• Personal insolvency or bankruptcy
• Criminal conviction
• Loss of professional license
• Resignation or termination of employment

A buy-sell should set forth the purchase price or a formula for determining the purchase price. Without establishing this price in advance, lengthy disputes and lawsuits can arise at the time the ownership interest must be bought back.

Fixing the estate tax value of a business interest

One of the advantages of buy-sells is the ability to fix the purchase price as the estate tax value of a deceased owner’s business interest, which can help avoid future valuation problems with the IRS. When using a buy-sell to set the estate tax value of a business interest, careful drafting is essential. To pass muster, all buy-sells must pass the following four-part test:

1. The estate must be obligated to sell the business interest at the price set forth in the buy-sell
2. The buy-sell must place certain restrictions on lifetime transfers of the business interest
3. The value of the business interest must be fixed by, or determined from, the buy-sell
4. The buy-sell must be a bona fide business arrangement, and not a transfer for less than adequate consideration

When the buy-sell involves family members, it must also be proven that the transaction is comparable to arms-length sales between unrelated persons, and was entered into for a bona fide business purpose.

Caution: Determining the fair market value of a business may require an independent business valuator. The IRS can impose harsh penalties for understating the value of an asset for estate tax purposes.

Financing the buyout

For a buy-sell to be successful, funds must be available to carry out the terms of the buy-sell. Without a funding plan in place, the buyer(s) may be forced to sell assets, take out loans, or even file for bankruptcy.

There are several ways to fund a buy-sell, including:

• Cash
• Borrowings
• Installment sale
• Self-canceling installment note
• Private annuity
• Stock redemption
• Sale-leaseback
• Appreciated property bailout
• Deferred compensation
• Life insurance
• Disability insurance

Factors that generally influence the choice of funding method include:

• Business structure, size, and tax bracket
• Number of owners, their ages, tax brackets, and ownership percentages
• Levels of cash or credit available to the business or the owners
• Type of buy-sell agreement

Depending upon the specific details, there might be just one funding method that is appropriate, or there may be several funding methods that could be used.

Structuring buy-sells

Buy-sells can be structured to meet the needs of both the business and the owners, taking into consideration tax consequences and individual goals. There are four basic structures for buy-sells, and some combinations are possible. A very brief description of the four basic structures follows.

1. An entity purchase buy-sell obligates the business to buy the interests of each departing or deceased owner.
2. With a cross purchase buy-sell, each owner agrees to buy a share of a departing or deceased owner’s interest. The business is not a party to this type of buy-sell.
3. A unilateral or one-way buy-sell is used when only one owner is selling an interest, and is typically used in sole ownership situations where the owner is arranging to sell the entire business to a family member or key employee.
4. A wait-and-see buy-sell is used when the parties are unsure whether the business or the owners will buy the business interest. Typically, the business is given the first option, and if it does not exercise the option, the remaining owners are given the opportunity. If the remaining owners do not exercise their option, the business is obligated to buy the interest, just as with an entity purchase buy-sell.

Tip: It is not necessary that the same buy-sell apply to all the owners of a business.

Suitable clients

• Business owners who do not want to be forced to work with or share control of the business with a stranger who buys an interest from a departing owner
• Business owners who do not want to be forced to work with a spouse or other family member of a deceased or divorced co-owner
• Business owners who do not want to end up co-owning the business with a bankruptcy trustee or creditor if a co-owner experiences personal financial difficulties
• Business owners who do not want their heirs to inherit a business for which they cannot get a fair price
• Business owners who do not want to engage in pricing disputes with heirs of deceased co-owners

Example

Steve and Jack are brothers who loved cars as teenagers. Steve could fix just about anything and Jack went to all the car shows and talked to anyone who would listen about the new models.

As soon as they graduated college, Steve and Jack borrowed some money and bought a car dealership. Over the years, they built a very successful business–Steve ran the operations while Jack took charge of sales and marketing.

While their business thrived, their personal lives flourished as well–each marrying and having several children. But then, one day, Jack unexpectedly had a heart attack and died. Jack’s family was overwhelmed with shock and grief. After several weeks, Jack’s widow, Norma, came by Steve’s office. Norma was very nervous–she needed to broach the subject of her husband’s interest in the dealership, but knew Steve was having a difficult time managing the business on his own. Norma was having her own financial difficulties, however, having a large mortgage to pay and two children in college. She couldn’t put off this meeting, even if it resulted in tension and bad feelings.

To her delightful surprise, Norma soon discovered how much foresight her husband and brother-in-law possessed. They had executed a buy-sell agreement many years ago, just in case such an unfortunate event should occur, and financed the agreement with life insurance policies on each other’s lives. Steve was in the process of claiming the proceeds and would pay Norma the agreed-upon purchase price.

Norma received her rightful share of the business, in cash, with which she was able to meet her family’s needs. Steve was able to continue the business with no interference. And though it wasn’t quite the same, he hired a sales and marketing manager to take over his brother’s duties, and the dealership continued to operate successfully.

Advantages

• Assures continuation of a business
• Assures a smooth transition of a business
• May prevent loss of entity status due to restrictions on transfers of interests (S corporations and limited liability companies)
• Provides assurance to creditors, customers, and employees
• Guarantees a buyer for a departing owner’s interest
• Can prevent outsiders from gaining control of business
• Establishes a taxable value in advance, minimizing estate taxes and potential valuation conflicts with IRS at time of owner’s death
• Protects heirs from unfair treatment
• Ensures estate liquidity

Disadvantages

• Depending on the type of buy-sell, there could be adverse income tax consequences to the business and/or the owners
• Meticulous drafting is required–improperly drafted buy-sells can result in unintended consequences and tax code violations
• Valuations may need to be updated from time to time
• If funded with insurance, care must be taken to provide continuing coverage

Waddell & Reed
Mahari A. McTier
Financial Advisor
2809 Butterfield Rd
Suite 170
Oak Brook IL 60523
(630) 954-4611ex: 141
205-266-1570
mmctier@wradvisors.com
www.mmctier.wradvisors.com

Teach Your Children Well: Basic Financial Education

Even before your children can count, they already know something about money: it’s what you have to give the ice cream man to get a cone, or put in the slot to ride the rocket ship at the grocery store. So, as soon as your children begin to handle money, start teaching them how to handle it wisely.

Making allowances

Giving children allowances is a good way to begin teaching them how to save money and budget for the things they want. How much you give them depends in part on what you expect them to buy with it and how much you want them to save.

Some parents expect children to earn their allowance by doing household chores, while others attach no strings to the purse and expect children to pitch in simply because they live in the household. A compromise might be to give children small allowances coupled with opportunities to earn extra money by doing chores that fall outside their normal household responsibilities.

When it comes to giving children allowances:

* Set parameters. Discuss with your children what they may use the money for and how much should be saved.
* Make allowance day a routine, like payday. Give the same amount on the same day each week.
* Consider “raises” for children who manage money well.

Take it to the bank

Piggy banks are a great way to start teaching children to save money, but opening a savings account in a “real” bank introduces them to the concepts of earning interest and the power of compounding.

MotherGirlPiggyBank While children might want to spend all their allowance now, encourage them (especially older children) to divide it up, allowing them to spend some immediately, while insisting they save some toward things they really want but can’t afford right away. Writing down each goal and the amount that must be saved each week toward it will help children learn the difference between short-term and long-term goals. As an incentive, you might want to offer to match whatever children save toward their long-term goals.

Shopping sense

Television commercials and peer pressure constantly tempt children to spend money. But children need guidance when it comes to making good buying decisions. Teach children how to compare items by price and quality. When you’re at the grocery store, for example, explain why you might buy a generic cereal instead of a name brand.

By explaining that you won’t buy them something every time you go to a store, you can lead children into thinking carefully about the purchases they do want to make. Then, consider setting aside one day a month when you will take children shopping for themselves. This encourages them to save for something they really want rather than buying on impulse. For “big-ticket” items, suggest that they might put the items on a birthday or holiday list.

Don’t be afraid to let children make mistakes. If a toy breaks soon after it’s purchased, or doesn’t turn out to be as much fun as seen on TV, eventually children will learn to make good choices even when you’re not there to give them advice.

Earning and handling income

Older children (especially teenagers) may earn income from part-time jobs after school or on weekends. Particularly if this money supplements any allowance you give them, wages enable children to get a greater taste of financial independence.

Earned income from part-time jobs might be subject to withholdings for FICA and federal and/or state income taxes. Show your children how this takes a bite out their paychecks and reduces the amount they have left over for their own use.

Creating a balanced budget

With greater financial independence should come greater fiscal responsibility. Older children may have more expenses, and their extra income can be used to cover at least some of those expenses. To ensure that they’ll have enough to make ends meet, help them prepare a budget.

To develop a balanced budget, children should first list all their income. Next, they should list routine expenses, such as pizza with friends, money for movies, and (for older children) gas for the car. (Don’t include things you will pay for.) Finally, subtract the expenses from the income. If they’ll be in the black, you can encourage further saving or contributions to their favorite charity. If the results show that your children will be in the red, however, you’ll need to come up with a plan to address the shortfall.

To help children learn about budgeting:

• Devise a system for keeping track of what’s spent
• Categorize expenses as needs (unavoidable) and wants (can be cut)
• Suggest ways to increase income and/or reduce expenses

The future is now

Teenager Teenagers should be ready to focus on saving for larger goals (e.g., a new computer or a car) and longer-term goals (e.g., college, an apartment). And while bank accounts may still be the primary savings vehicles for them, you might also want to consider introducing your teenagers to the principles of investing.

To do this, open investment accounts for them. (If they’re minors, these must be custodial accounts.) Look for accounts that can be opened with low initial contributions at institutions that supply educational materials about basic investment terms and concepts.

Helping older children learn about topics such as risk tolerance, time horizons, market volatility, and asset diversification may predispose them to take charge of their financial future.

Should you give the kid credit?

If older children (especially those about to go off to college) are responsible, consider getting them a credit card. Most major credit card companies require an adult to cosign a credit card agreement before they will issue a card to someone under the age of 18 (as of February 2010, the Credit CARD Act of 2009 will generally require this for consumers under age 21). Ask the credit card company for a low credit limit (e.g., $300) or a secured card. This can help children learn to manage credit without getting into serious debt.

Also:

• Set limits on the card’s use
• Make sure children understand the grace period, fee structure, and how interest accrues on the unpaid balance
• Agree on how the bill will be paid, and what will happen if the bill goes unpaid
• Make sure children understand how long it takes to pay off a credit card balance if they only make minimum payments

If putting a credit card in your child’s hands is a scary thought, you may want to start off with a prepaid spending card. A prepaid spending card looks like a credit card, but functions more like a prepaid phone card. The card can be loaded with a predetermined amount that you specify, and generally may be used anywhere credit cards are accepted. Purchases are deducted from the card’s balance, and you can transfer more money to the card’s balance whenever necessary. Although there may be some fees associated with the card, no debt or interest charges accrue; children can only spend what’s loaded onto the card.

One thing you might especially like about prepaid spending cards is that they allow children to gradually get the hang of using credit responsibly. Because you can access the account information online or over the phone, you can monitor the spending habits of your children. If need be, you can then sit down with them and discuss their spending behavior and money management skills.

Waddell & Reed
Mahari A. McTier
Financial Advisor
2809 Butterfield Rd
Suite 170
Oak Brook IL 60523
(630) 954-4611ex: 141
205-266-1570
mmctier@wradvisors.com
www.mmctier.wradvisors.com

Financial Aid 101

Many parents pay for college with a combination of savings and financial aid. Indeed, with the high cost of college today, financial aid might be the only way your child can afford to attend college. By learning the basics, you’ll be able to understand how the financial aid process works, properly fill out aid applications, and compare the aid awards your child receives.

What is financial aid?

Financial aid is money distributed primarily by the federal government and colleges in the form of student loans, grants, scholarships, and work-study jobs. Loans and work-study must be repaid (through monetary or work obligations), while grants and scholarships do not. A student can receive both federal and college aid.

Financial aid can be further broken down into two categories: need-based, which is dependent on your child’s financial need, and merit-based, which is awarded according to your child’s academic, athletic, musical, or artistic merit. Most financial aid is need-based.

How is financial need determined?

In its aid application, called the FAFSA (Free Application for Federal Student Aid), the federal government uses a formula known as the federal methodology. A detailed analysis of the formula is beyond the scope of this discussion, but generally speaking, your income and assets and your child’s income and assets are tallied and assessed at certain rates. You’re granted certain deductions and allowances against income, and you’re able to exclude certain assets from consideration, namely, your retirement plans, annuities, home equity, and cash value life insurance. The result is a figure known as your expected family contribution, or EFC. This is the amount of money you must contribute to college costs to be eligible for aid. Your EFC remains constant, no matter which college your child applies to.

Your EFC is not the same as your child’s financial need. To calculate your child’s financial need, subtract your EFC from the cost at a given college. Because tuition, fees, and room-and-board expenses are different at each college, your child’s financial need will vary depending on the cost of a particular college.

Example: You fill out the FAFSA and your EFC is calculated at $5,000. College A costs $18,000 per year and College B costs $30,000 per year. Your child’s financial need at College A is $13,000 and $25,000 at College B.

Colleges have their own way of determining financial aid. Basically, the process works the same way as with the federal government, except that the institutional methodology embodied in the standard college PROFILE application typically takes a more in-depth look at your income and assets to determine how “needy” your child really is. For example, colleges often consider your home equity and retirement accounts in assessing your ability to pay college costs.

How does financial need relate to the aid package?

Just because your child has financial need doesn’t necessarily mean that colleges will meet 100% of that need. In fact, it’s not uncommon for colleges to meet only a portion of that need, a phenomenon known as getting “gapped.” If this happens to you, you’ll have to make up the shortfall, in addition to paying your EFC. College guidebooks compare how well colleges meet their students’ financial need under the entry “average percentage of need met” or something similar.

How do I apply and when?

The FAFSA can be completed manually and mailed to the regional processor listed on the form, or it can be completed online and filed electronically at www.fafsa.ed.gov. The online route is probably better because mistakes are flagged immediately and electronic FAFSAs take only one week to process (compared to four to six weeks for paper FAFSAs).

The FAFSA relies on information from your previous year’s tax return, so it can’t be filed before January 1 in the year that your child will be attending college (the official federal deadline for filing the FAFSA is June 30, but many colleges have an earlier deadline). Parents should try to submit the FAFSA as close to January 1 as possible because some financial aid programs operate on a first-come, first-served basis. Even if you haven’t completed your federal income tax return, Uncle Sam lets you base your FAFSA answers on an estimated return, though you will have to provide a copy of your final income tax return later.

After your FAFSA is processed, your child will receive a Student Aid Report in the mail highlighting your EFC (the colleges that you list on the FAFSA will also get a copy of the report). Then, the financial aid administrator at each school will try to craft an aid package to meet your child’s financial need.

Comparing aid awards

Sometime in early spring, your child will receive financial aid award letters that detail the specific amount and type of financial aid that each college is offering. When comparing awards, first check to see if each college is meeting all of your child’s financial need. Then, look at the loan component of each award and compare actual out-of-pocket costs. Remember, grants and scholarships don’t have to be repaid and so don’t count toward out-of-pocket costs.

If you’d like to lobby a particular school for more aid, tread carefully. A polite letter to the financial aid administrator followed up by a telephone call is appropriate. Your chances for getting more aid are best if you can document a change in circumstances that affects your ability to pay, such as a recent job loss, unusually high medical bills, or some other unforeseen event. Also, your chances improve if your child has been offered more aid from a direct competitor college, because colleges generally don’t like to lose a prospective student to a direct competitor. Remember, the fewer loans, the better.

The most common federal aid programs

Here are some names you’ll be hearing as you navigate the world of financial aid:

• Stafford Loan–The most common low-interest, federal student loan for college and graduate students. Interest may be subsidized (paid by the government during school, the grace period and deferment periods) or unsubsidized. The interest rate is fixed at 6.8% for new loans (this rate will gradually be reduced to 3.4% by 2012).
• Perkins Loan–A low-interest, federal student loan for college and graduate students with the greatest financial need. The interest rate is fixed at 5%.
• PLUS Loan–A federal education loan for parents of college students (and independent graduate students), available through financial institutions. A separate application is required, though filing the FAFSA first is a prerequisite. Parents can borrow the full cost of their child’s education, less any financial aid received; the only criteria is a good credit history. The interest rate is fixed at 8.5% for new loans.
• Pell and SEOG Grants–These grants are available to undergraduate students with exceptional financial need.

A word about merit aid

In recent years, merit aid has been making a comeback as colleges (especially private colleges) use favorable merit aid packages to attract certain students to their campuses, regardless of their financial need. However, the availability of college-sponsored merit aid tends to fluctuate from year to year as colleges decide how much of their endowments to spend, as well as which specific academic and extracurricular programs they want to target.

Besides colleges, a wide variety of groups offer merit scholarships to students meeting certain criteria. There are several websites where your child can input his or her background, abilities, and interests and receive (free of charge) a matching list of potential scholarships. Then it’s up to your child to meet the various application deadlines. Though this avenue is worth exploring, it shouldn’t come at the expense of filling out the FAFSA and college applications.

How much should you rely on financial aid?

With all this talk of financial aid, it’s easy to assume that it will do most of the heavy lifting when it comes time to paying the college bills. But the reality is you shouldn’t rely too heavily on financial aid. Although aid can certainly help cover your child’s college costs, student loans make up the largest percentage of the typical aid package, not grants and scholarships.

As a general rule of thumb, plan on student loans covering up to 50% of college expenses, grants and scholarships covering up to 15%, and work-study jobs covering a variable amount. But remember, parents and students who rely mainly on loans to finance college can end up with a considerable debt burden. So try to save as much as you can beforehand.

Waddell & Reed
Mahari A. McTier
Financial Advisor
2809 Butterfield Rd
Suite 170
Oak Brook IL 60523
(630) 954-4611ex: 141
205-266-1570
mmctier@wradvisors.com
www.mmctier.wradvisors.com

Stimulus package for job seekers

By Kate Lorenz on Feb 20, 2009 in Current Affairs, Employment, Employment Trends, Featured

Now that Congress has passed and President Obama has signed the $787 billion American Reinvestment and Recovery Plan, its intent is to create or save up to 4 million jobs over the next two years.

If you’re a job seeker, no doubt you’re probably wondering: What does this mean for me? What kind of jobs will be created?

We’ve scoured President Obama’s remarks, detailed information about the legislation, and key provisions on Speaker Nancy Pelosi’s Web site to answer your most burning questions.

How will the jobs be created?
“The goal at the heart of this plan is to create jobs — not just any jobs, but jobs doing the work America needs done:  repairing our infrastructure, modernizing our schools and our hospitals, promoting the clean, alternative energy sources that will help us finally declare our independence from foreign oil, ” said President Obama.

Those jobs will projects will create almost half of the projected jobs including the modernization of roads and bridges (835,000 jobs); public transit and rail improvements (200,000 jobs); prioritizing clean water, flood control and environment restoration (375,000).

The rest of the job creation is expected as small and large American businesses garner new business opportunities, via small business loans and tax incentives.

Watch this video detailing the President’s plan.

What industries will be targeted?
Ninety percent of the jobs created will be in the private sector. Funding will be extended to all types of industries and companies, but it focuses on:

• Construction
• Science
• Technology
• Energy
• Engineering
• Education
• Health care
• Law enforcement

How will this work?
Federal and state agencies will create the jobs/projects that need to be done. When companies are selected for the work and funding, preference will be given to those who can begin spending within six months - that is, create jobs quickly.

This creates a trickle-down of work. For example: An engineering firm that wins a contract, will need to increase staff to handle the work and also hire materials suppliers, which in turn would need to hire workers to handle the new invoicing that comes through.

How can I find these newly created jobs?
If you want to know what opportunities will be available in your area, The White House blog posted “Jobs in all 50 states” last week which gave more information about where the actual number of jobs came from and a fact sheet on state-by-state job creation details.

In addition, the government has created an oversight board and a Web site Recovery.gov, to show the public where the money is going - the contracts that are available and the companies that receive them.

Granted, this plan isn’t as neat a picture as I’ve painted. It’s complicated and still being dissected. We’ll keep talking about it. Tell us what you think.

Teaching Your Teen about Money

Your teen is becoming more independent, but still needs plenty of advice from you. With more money to spend and more opportunities to spend it, your teen can easily get into financial trouble. So before money burns a hole in your child’s pocket, teach him or her a few financial lessons. With your help, your teen will soon develop the self-confidence and skills he or she needs to successfully manage money in the real world.

Lesson 1: Handling earnings from a job

Teens often have more expenses than younger children, and your child may be coming to you for money more often. But with you holding the purse strings, your teen may have difficulty making independent financial decisions.

One solution? Encourage your teen to get a part-time job that will enable him or her to earn money for expenses. Here are some things you might want to discuss with your teen when he or she begins working:

• Agree on what your child’s pay should be used for. Now that your teen is working, will he or she need to help out with car insurance or clothing expenses, or do you want your teen to earmark a portion of each paycheck for college?
• Talk to your teen about taxes. Show your child how FICA taxes and regular income taxes can take a bite out of his or her take-home pay.
• Introduce your teen to the concept of paying yourself first. Encourage your teen to deposit a portion of every paycheck in a savings account before spending any of it.

A teen who is too young to get a job outside the home can make extra cash by babysitting or doing odd jobs for you, neighbors, or relatives. This money can supplement any allowance you choose to hand out, enabling your young teen to get a taste of financial independence.

Lesson 2: Developing a budget

Developing a written spending plan or budget can help your teen learn to be accountable for his or her finances. Your ultimate goal is to teach your teen how to achieve a balance between money coming in and money going out. To develop a spending plan, have your teen start by listing out all sources of regular income (e.g., an allowance or earnings from a part-time job). Next, have your teen brainstorm a list of regular expenses (don’t include anything you normally pay for). Finally, subtract your teen’s expenses from his or her income. If the result shows that your teen won’t have enough income to meet his or her expenses, you’ll need to help your teen come up with a plan for making up the shortfall.

Here are some ways you can help your teen learn about budgeting:

• Consider giving out a monthly, rather than weekly, allowance. Tell your teen that the money must last for the whole month, and encourage him or her to keep track of what’s been spent.
• Encourage your teen to think spending decisions through rather than buying items right away. Show your teen how comparing prices or waiting for an item to go on sale can save him or her money.
• Suggest ways your teen can earn more money or cut back on expenses (e.g., rent a DVD to watch with friends rather than go to the movies) to resolve a budget shortfall.
• Show your teen how to modify a budget by categorizing expenses as needs (expenses that are unavoidable) and wants (expenses that could be cut if necessary).
• Resist the temptation to bail your teen out. If your teen can depend on you to come up with extra cash, he or she will never learn to manage money wisely. But don’t be judgmental–your teen will inevitably make some spending mistakes along the way. Your child should know that he or she can always come to you for information, support, and advice.

Lesson 3: Saving for the future

As a youngster, your child saved up for a short-term goal such as buying a favorite toy. But now that your child is a teen, he or she is ready to focus on saving for larger goals such as a new computer or a car and longer-term goals such as college. Here are some ways you can encourage your teen to save for the future:

• Have your teen put savings goals in writing to make them more concrete.
• Encourage your child to set goals that are based on his or her values, not on keeping up with what other teens have or want.
• Motivate your child by offering to match what he or she saves towards a long-term goal. For instance, for every dollar your child sets aside for college, you might contribute 50 cents or 1 dollar.
• Consider increasing your teen’s allowance if he or she is too young to get a part-time job.
• Praise your teen for showing responsibility when he or she reaches a financial goal. Teens still look for, and count on, their parent’s approval.
• Open up a savings account for your child if you haven’t already done so.
• Introduce your teen to the basics of investing by opening an investment account for your teen (if your teen is a minor, this will be a custodial account). Look for an account that can be opened with only a low initial contribution at an institution that supplies educational materials introducing teens to basic investment terms and concepts.

Lesson 4: Using credit wisely

You can take some comfort in the fact that most major credit card companies require an adult to cosign a credit card agreement before they will issue a card to someone under the age of 18, but you can’t ignore the credit card issue altogether. Many teens today use credit cards, and it probably won’t be long until your teen asks for one too.

If you decide to cosign a credit card application for your teen, ask the credit card company to assign a low credit limit (e.g., $300). This can help your child learn to manage credit without getting into serious debt.

Here are some things to discuss with your teen before he or she uses a credit card:

• Set limits on what the card can be used for (e.g., emergencies, clothing).
• Review the credit card agreement, and make sure your child understands how much interest will accrue on the unpaid balance, what grace period applies, and what fees will be charged.
• Agree on how the bill will be paid, and what will happen if your child can’t pay the bill.
• Make sure your child understands how long it will take to pay off a credit card balance if he or she only makes minimum payments. You can demonstrate this using an online calculator.

If putting a credit card in your teen’s hands is a scary thought, you may want to start off with a prepaid spending card. A prepaid spending card looks like a credit card, but works more like a prepaid phone card. You load the card with the dollar amount you choose and your teen can generally use it anywhere a credit card is accepted. Your teen’s purchases are deducted from the card balance, and you can transfer more money to the card if necessary. Although there may be some fees associated with the card, no interest or debt accrues.

One thing you may especially like about prepaid spending cards is that they allow your teen to gradually get the hang of using credit responsibly. Because you can access account information online or over the phone, you can monitor your teen’s spending habits, then sit down and talk with your teen about money management issues.

Waddell & Reed
Mahari A. McTier
Financial Advisor
2809 Butterfield Rd
Suite 170
Oak Brook IL 60523
(630) 954-4611
mmctier@wradvisors.com

10 Financial Commandments for Your 30’s

Life moves fast. You think you have all the time in the world, then suddenly your twenties are over and you’re, like, a real adult.

Welcome to your thirties. The past decade was all about life’s changes and getting to know yourself — and your finances (see 10 Financial Commandments for Your 20s). You know the basics for managing your money. Now it’s time to build on that foundation and secure your financial future.

Here are ten principles that should be carved in stone for every thirtysomething:

1. Pay off your nonmortgage debt. Your thirties bring financial responsibilities you may not have had in your twenties, such as a mortgage or a family. Nothing frees up cash to meet those obligations like getting rid of your debt. We hope you paid off your credit cards in your twenties (if you didn’t, make it a top priority). Next, focus on getting rid of student loans and other nonmortgage debt, such as auto loans.

2. Kick the debt cycle altogether. What good is it to pay off your loans only to take out another one and rack up more debt? An easy way to save for big-ticket items — and avoid going back into debt — is to put money you would have used for monthly debt payments and interest charges into a savings account. For instance, after you make that final $300-per-month student-loan payment, keep making an equal payment to yourself. After one year, you’ll have $3,600 saved. See When Is It Worth Going Into Debt? to learn more.

3. Get serious about retirement. Your twenties were the time to start investing. No matter how little money you had to spare, it gave you a great head start. Now it’s time to look at your goals and set a plan in motion to reach them. We have a handy calculator that’ll help you crunch the numbers.

Basically, you need to figure out when you want to retire, how much money you want to have by then and how much money you’ll need to sock away now to reach that goal. Time is still on your side — use it! Get serious now so you can have a comfortable retirement without sacrificing too much in the meantime. Wait until your forties or fifties and saving could become downright painful.

Don’t be tempted to save for your kids’ college expenses instead of saving for retirement. Make sure your own plans are on track first. After all, there are loans to pay for college, but not for retirement.

4. Diversify your investments. You want to make sure your money is spread among different types of investments to protect yourself in case one sector of the market tanks.

Generally, you should aim to allocate 50% to 55% of your portfolio to large companies, evenly split between growth and value; 20% to 25% to small companies, evenly split between growth and value; and 25% to foreign companies. Check out our sample long-term portfolio for fund recommendations. Or, use Kiplinger’s Fund Finder to zero in on funds in each category that meet your performance criteria.

See The Five Keys to Investing Success to take your investing skills to the next level.

5. Continue to learn. Don’t stop investing in yourself once you land a job. “Keep your earning power growing through continuous education, training and personal development,” advises Knight Kiplinger, editor in chief of Kiplinger.com.

6. Protect your assets. Even the best-laid financial plans can be derailed by an unexpected cost. So it pays to be prepared for the “what ifs” in life. For most thirtysomethings, that means having adequate homeowner’s (or renter’s) insurance, health insurance and disability insurance.

It also means having an ample emergency fund. You started stocking your fund in your twenties, but by your thirties, you should have the full stash of money to cover three to six months’ worth of expenses in case of a job loss, medical emergency or other surprise.

7. Live simply. Deferred gratification may not be fun, but adopting a simple lifestyle is one of the surest ways to meet today’s needs and still reach your long-term goals. Take a look at your spending to identify areas you could trim the fat (see Save Money on Practically Everything). Small sacrifices can, indeed, add up to big rewards.

It’s easy to get jealous of friends and family who are living larger and seem to be doing much better than you. Remember, keeping up with the Joneses is a losing game. Someone else’s success may be a facade. Tune out the financial peer pressure around you and focus solely on what you know for certain: the state of your own personal finances.

8. Make your will known. A will ensures your wishes are carried out should the unthinkable happen. Many assume that wills are for people who are old, rich, married or have kids. But everyone needs a will to spell out their wishes in case they die or can’t make medical decisions for themselves (see Wills for the Young, Single or Broke).

If you do have children, make sure your will designates a guardian to care for them should something happen to both you and their other parent.

9. Get a life … insurance policy. If you have children (or someone else who depends on you financially), life insurance  is a must. If you were to die, you’d want to make sure they were secure. When you’re in your thirties, you can get a great deal on term life insurance. You buy a policy that lasts for a certain amount of time — say, until the kids are grown. For instance, we recently shopped for a 32-year-old nonsmoking male and found a $500,000, 20-year term life policy for as little as $275 a year.

10. Be charitable. As you become more established in life and in your finances, take the opportunity to give something back. Being charitable and socially conscious can be rewarding — not to mention financially smart, considering the tax write-offs you get if you itemize on your return.

If the new responsibilities of your thirties have you feeling strapped for cash, give of yourself, not of your wallet. Volunteer your time or talents for a cause you believe in — it doesn’t cost a lot to make a difference. (See A Dozen Creative Donations for more no- or low-cash ways you can give to charity.)
source kiplinger.com

Balancing Your Investment Choices with Asset Allocation

A chocolate cake. Pasta. A pancake. They’re all very different, but they generally involve flour, eggs, and perhaps a liquid. Depending on how much of each ingredient you use, you can get very different outcomes. The same is true of your investments. Balancing a portfolio means combining various types of investments using a recipe that’s right for you.

Getting the right mix

The combination of investments you choose can be as important as your specific investments. The mix of various asset classes, such as stocks, bonds, and cash equivalents, accounts for most of the ups and downs of a portfolio’s returns.

There’s another reason to think about the mix of investments in your portfolio. Each type of investment has specific strengths and weaknesses that enable it to play a specific role in your overall investing strategy. Some investments may be chosen for their growth potential. Others may provide regular income. Still others may offer safety or simply serve as a temporary place to park your money. And some investments even try to fill more than one role. Because you probably have multiple needs and desires, you need some combination of investment types.

Balancing how much of each you should include is one of your most important tasks as an investor. That balance between growth, income, and safety is called your asset allocation. It doesn’t guarantee a profit or insure against a loss, but it does help you manage the level and type of risks you face.

Balancing risk and return

Ideally, you should strive for an overall combination of investments that minimizes the risk you take in trying to achieve a targeted rate of return. This often means balancing more conservative investments against others that are designed to provide a higher return but that also involve more risk. For example, let’s say you want to get a 7.5% return on your money. Your financial professional tells you that in in the past, stock market returns have averaged about 10% annually, and bonds roughly 5%. One way to try to achieve your 7.5% return would be by choosing a 50-50 mix of stocks and bonds. It might not work out that way, of course. This is only a hypothetical illustration, not a real portfolio, and there’s no guarantee that either stocks or bonds will perform as they have in the past. But asset allocation gives you a place to start.

Someone living on a fixed income, whose priority is having a regular stream of money coming in, will probably need a very different asset allocation than a young, well-to-do working professional whose priority is saving for a retirement that’s 30 years away. Many publications feature model investment portfolios that recommend generic asset allocations based on an investor’s age. These can help jump-start your thinking about how to divide up your investments. However, because they’re based on averages and hypothetical situations, they shouldn’t be seen as definitive. Your asset allocation is–or should be–as unique as you are. Even if two people are the same age and have similar incomes, they may have very different needs and goals. You should make sure your asset allocation is tailored to your individual circumstances.

Many ways to diversify

When financial professionals refer to asset allocation, they’re usually talking about overall classes: stocks, bonds, and cash or cash equivalents. However, there are others that also can be used to complement the major asset classes once you’ve got those basics covered. They include real estate and alternative investments such as hedge funds, private equity, metals, or collectibles. Because their returns don’t necessarily correlate closely with returns from major asset classes, they can provide additional diversification and balance in a portfolio.

Even within an asset class, consider how your assets are allocated. For example, if you’re investing in stocks, you could allocate a certain amount to large-cap stocks and a different percentage to stocks of smaller companies. Or you might allocate based on geography, putting some money in U.S. stocks and some in foreign companies. Bond investments might be allocated by various maturities, with some money in bonds that mature quickly and some in longer-term bonds. Or you might favor tax-free bonds over taxable ones, depending on your tax status and the type of account in which the bonds are held.

Asset allocation strategies

There are various approaches to calculating an asset allocation that makes the most sense for you.

The most popular approach is to look at what you’re investing for and how long you have to reach each goal. Those goals get balanced against your need for money to live on. The more secure your immediate income and the longer you have to achieve your investing goals, the more aggressively you might be able to invest for them. Your asset allocation might have a greater percentage of stocks than either bonds or cash, for example. Or you might be in the opposite situation. If you’re stretched financially and would have to tap your investments in an emergency, you’ll need to balance that fact against your longer-term goals. In addition to establishing an emergency fund, you may need to invest more conservatively than you might otherwise want to.

Some investors believe in shifting their assets among asset classes based on which types of investments they expect will do well or poorly in the near term. However, this approach, called “market timing,” is extremely difficult even for experienced investors. If you’re determined to try this, you should probably get some expert advice–and recognize that no one really knows where markets are headed.

Some people try to match market returns with an overall “core” strategy for most of their portfolio. They then put a smaller portion in very targeted investments that may behave very differently from those in the core and provide greater overall diversification. These often are asset classes that an investor thinks could benefit from more active management.

Just as you allocate your assets in an overall portfolio, you can also allocate assets for a specific goal. For example, you might have one asset allocation for retirement savings and another for college tuition bills. A retired professional with a conservative overall portfolio might still be comfortable investing more aggressively with money intended to be a grandchild’s inheritance. Someone who has taken the risk of starting a business might decide to be more conservative with his or her personal portfolio.

Things to think about

• Don’t forget about the impact of inflation on your savings. As time goes by, your money will probably buy less and less unless your portfolio at least keeps pace with the inflation rate. Even if you think of yourself as a conservative investor, your asset allocation should take long-term inflation into account.
• Your asset allocation should balance your financial goals with your emotional needs. If the way your money is invested keeps you awake worrying at night, you may need to rethink your investing goals and whether the strategy you’re pursuing is worth the lost sleep.
• Your tax status might affect your asset allocation, though your decisions shouldn’t be based solely on tax concerns.

Even if your asset allocation was right for you when you chose it, it may not be right for you now. It should change as your circumstances do and as new ways to invest are introduced. A piece of clothing you wore 10 years ago may not fit now; you just might need to update your asset allocation, too.

Waddell & Reed
Mahari A. McTier
Financial Advisor

New Law Provides Housing Relief

On July 30, 2008, President Bush signed H.R. 3221, the Housing and Economic Recovery Act of 2008 (the Act), which provides assistance to homeowners facing foreclosure and stretches a safety net under a troubled housing market. The Act establishes a new regulatory agency to oversee Fannie Mae, Freddie Mac, and the Federal Home Loan Banks, gives the Treasury Department the authority to extend credit to these government-sponsored enterprises, and modifies FHA loan limits. The Act includes multiple additional provisions, including the following, which may be of interest to individual homeowners. Read more

Monitoring Your Portfolio

You probably already know you need to monitor your investment portfolio and update it periodically. Even if you’ve chosen an asset allocation, market forces may quickly begin to tweak it. For example, if stock prices go up, you may eventually find yourself with a greater percentage of stocks in your portfolio than you want. If stock prices go down, you might worry that you won’t be able to reach your financial goals. The same is true for bonds and other investments.

Do you have a strategy for dealing with those changes? You’ll probably want to take a look at your individual investments, but you’ll also want to think about your asset allocation. Just like your initial investing strategy, your game plan for fine-tuning your portfolio periodically should reflect your investing personality.

The simplest choice is to set it and forget it–to make no changes and let whatever happens happen. If you’ve allocated wisely and chosen good investments, you could simply sit back and do nothing. But even if you’re happy with your overall returns and tell yourself, “if it’s not broken, don’t fix it,” remember that your circumstances will change over time. Those changes may affect how well your investments match your goals, especially if they’re unexpected. At a minimum, you should periodically review the reasons for your initial choices to make sure they’re still valid.

Even things out

To bring your asset allocation back to the original percentages you set for each type of investment, you’ll need to do something that may feel counterintuitive: sell some of what’s working well and use that money to buy investments in other sectors that now represent less of your portfolio. Typically, you’d buy enough to bring your percentages back into alignment. This keeps what’s called a “constant weighting” of the relative types of investments.

Let’s look at a hypothetical illustration. If stocks have risen, a portfolio that originally included only 50% in stocks might now have 70% in equities. Rebalancing would involve selling some of the stock and using the proceeds to buy enough of other asset classes to bring the percentage of stock in the portfolio back to 50. This doesn’t represent actual returns; it merely demonstrates how rebalancing works. Maintaining those relative percentages not only reminds you to take profits when a given asset class is doing well, but it also keeps your portfolio in line with your original risk tolerance.

When should you do this? One common rule of thumb is to rebalance your portfolio whenever one type of investment gets more than a certain percentage out of line–say, 5 to 10%. You could also set a regular date. For example, many people prefer tax time or the end of the year. To stick to this strategy, you’ll need to be comfortable with the fact that investing is cyclical and all investments generally go up and down in value from time to time.

Forecast the future

You could adjust your mix of investments to focus on what you think will do well in the future, or to cut back on what isn’t working. Unless you have an infallible crystal ball, it’s a trickier strategy than constant weighting. Even if you know when to cut back on or get out of one type of investment, are you sure you’ll know when to go back in?

Mix it up

You could also attempt some combination of strategies. For example, you could maintain your current asset allocation strategy with part of your portfolio. With another portion, you could try to take advantage of short-term opportunities, or test specific areas that you and your financial professional think might benefit from a more active investing approach. By monitoring your portfolio, you can always return to your original allocation.

Another possibility is to set a bottom line for your portfolio: a minimum dollar amount below which it cannot fall. If you want to explore actively managed or aggressive investments, you can do so–as long as your overall portfolio stays above your bottom line. If the portfolio’s value begins to drop toward that figure, you would switch to very conservative investments that protect that baseline amount. If you want to try unfamiliar asset classes and you’ve got a financial cushion, this strategy allows allocation shifts while helping to protect your core portfolio.

Points to consider

• Keep an eye on how different types of assets react to market conditions. Part of fine-tuning your game plan might involve putting part of your money into investments that behave very differently from the ones you have now. Diversification can have two benefits. Owning investments that go up when others go down might help to either lower the overall risk of your portfolio or improve your chances of achieving your target rate of return. Asset allocation and diversification don’t guarantee a profit or insure against a possible loss, of course. But you owe it to your portfolio to see whether there are specialized investments that might help balance out the ones you have.
• Be disciplined about sticking to whatever strategy you choose for monitoring your portfolio. If your game plan is to rebalance whenever your investments have been so successful that they alter your asset allocation, make sure you aren’t tempted to simply coast and skip your review altogether. At a minimum, you should double-check with your financial professional if you’re thinking about deviating from your strategy for maintaining your portfolio. After all, you probably had good reasons for your original decision.
• Check to see that the nature of what you’ve invested in hasn’t changed. For example, you may have a mutual fund that’s investing more overseas now than it was when you originally bought it. That could mean that your overall international exposure is higher now than when you first invested. This kind of “style drift” can affect the risk you’re taking without your knowing it.
• Some investments don’t fit neatly into a stocks-bonds-cash asset allocation. You’ll probably need help to figure out how hedge funds, real estate, private equity, and commodities might balance the risk and returns of the rest of your portfolio. And new investment products are being introduced all the time; you may need to see if any of them meet your needs better than what you have now.

Balance the costs against the benefits of rebalancing

Don’t forget that too-frequent rebalancing can have adverse tax consequences for taxable accounts. Since you’ll be paying capital gains taxes if you sell a stock that has appreciated, you’ll want to check on whether you’ve held it for at least one year. If not, you may want to consider whether the benefits of selling immediately will outweigh the higher tax rate you’ll pay on short-term gains. This doesn’t affect accounts such as 401(k)s or IRAs, of course. In taxable accounts, you can avoid or minimize taxes in another way. Instead of selling your portfolio winners, simply invest additional money in asset classes that have been outpaced by others. Doing so can return your portfolio to its original mix.

You’ll also want to think about transaction costs; make sure any changes you’re contemplating are cost-effective. No matter what your strategy, work with your financial professional to keep your portfolio on track.

Waddell & Reed
Mahari A. McTier
Financial Advisor
2809 Butterfield Rd
Suite 170
Oak Brook IL 60523
(630) 954-4611
mmctier@wradvisors.com