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Cash Management
Cash management strategies include budgeting, keeping financial records, maximizing the interest earned on checking and savings accounts, and regularly preparing financial statements, such as net worth and cash flow. One of the soundest pieces of financial advice is to spend less than you earn. It sounds simple, but if you are not fully aware of how you spend money, you may be spending more than you realize. After you track your income and expenses, following a spending plan (budget) that is adjusted to your individual situation and goals is an excellent strategy to plan your spending.
To estimate the value of your assets and chart your financial progress, each year you should add together everything you own (assets), then subtract everything you owe (debts), including your mortgage and credit card debt. This summary of assets and debts is called a net worth statement or balance sheet. It will help you analyze the way you currently manage your finances and make decisions to improve your financial situation.
You want your net worth to increase each year. During the early stages of your life, when you’re establishing yourself at work and accumulating the necessities of life, your net worth may rise slowly. It will probably grow the most right before retirement when you are at the peak of your career and accumulating assets to ensure a secure retirement. Plan to review and update your net worth annually. The actual date of your review is not important. It might be your birthday, New Year’s, right after you do your taxes, or some other important date. It is more important that you remember the date and complete your annual checkup. It also is important to regularly reconcile bank and other financial statements with your own records.
A vital aspect of the cash management building block is financial record-keeping. An effective record-keeping system should be convenient and not too complicated to maintain. A number of systems are available commercially, or you can design your own (e.g., with file folders). It is important that the system makes sense to you and that you use it consistently.
Emergency Cash Reserve
Setting aside money to meet unexpected expenses provides a financial safety net and allows you to take advantage of financial opportunities as they arise. Most experts recommend an emergency fund equal to 3 to 6 months living expenses; however, you do not need to set aside this total amount in a low-yielding passbook, certificate of deposit, or money market account. The amount of your emergency fund depends upon your age, health, job outlook, and personal financial situation (e.g., amount and kind of insurance coverage). An emergency fund might be adequate with enough to cover 3 to 6 months of expenses using a combination of cash and credit if you have a source of low-cost borrowing (e.g., home equity credit-line loan, cash-value life insurance, or retirement plan). If your household has multiple sources of income or dual earners, you can count on those other sources of income in an emergency.
You might want a larger emergency fund if you are in business for yourself, your work is seasonal, your job is uncertain, or you rely heavily on commissions. If your health is questionable (e.g., you foresee long-term disability or extensive medical expenses), you anticipate a large expenditure for the care of a relative in the near future, or your child is about to enter college, you may also need a larger cash reserve.
Your emergency cash reserve can be subdivided to minimize penalties for early withdrawal of large amounts of funds at one time and to maximize interest earned on accounts should an emergency occur. Money that would be needed within 3 months of a financial emergency is best placed in an interest-bearing checking account, passbook savings, money-market deposit account, or money market mutual fund. Funds needed 4 to 6 months after an emergency could be placed in short-term certificates of deposit (CDs) as well as 3- and 6-month Treasury bills. Money that would not be needed for 7 months to 2 years could be placed in a money market mutual fund and longer term CDs (12-, 18-, and 24-month). Money you can avoid withdrawing for 2 to 5 years during a financial emergency could be placed in Treasury notes, short-term bond funds, or 3- to 5-year CDs.
Risk Management
Every day we are exposed to many risks which can cause a financial loss. Accidents, property damage, illness, and death are risks we often consider. However, other risks, such as the possibility of being sued or becoming disabled and unable to work, are also important. We each have to decide how we will protect ourselves should a risk become a reality. If you do not have a plan, you might have to go into debt or use funds set aside for other financial goals in the event of financial disaster.
Appropriate risk management strategies protect against catastrophic financial losses, regardless of the cause. Good comprehensive insurance coverage against severe setbacks is essential. Areas for coverage include life, health, homeowner’s or renter’s, auto, disability, and liability. Smart consumers can obtain this coverage at a cost that allows them to move up the pyramid to accomplish other goals without being insurance poor. Note that this type of risk management should not be confused with investment risk, which is a different financial concept.
To determine when you need to purchase insurance, consider the best way to handle each of your risks. Because your risks change over a lifetime, evaluate your situation every few years and make appropriate changes. Can your savings cover a financial loss so that you don’t need to buy insurance? Increasing the deductibles (the portion of a loss that you pay) on your policy usually saves you money as well. However, when self-insuring or carrying high deductibles on policies, you must set aside the necessary funds in your emergency cash reserve to pay for those expenses in case of a loss.
Risk management strategies can be combined with savings and investments to achieve financial goals (e.g., buying cash value life insurance). However, be careful to ensure that your strategies provide the best return on the money involved. Determine if insurance protection can be purchased less expensively so that you can invest the savings for a greater overall return.
Tax Management
The goal for taxpayers is to pay no more than the least possible tax owed. Avoiding taxes through legal tax reduction strategies is not to be confused with illegal tax evasion. Legally avoiding taxes means using effective financial record-keeping, decision making, and planning strategies to reduce your total income tax . One example of good tax management is adjusting the amount of federal income tax withheld from your paycheck. If you receive a big income tax refund (over $500) each year, you are giving the federal government an interest-free loan. Evaluate the amount you have withheld and determine if you could use this money more effectively throughout the year to manage cash flow or invest for financial goals.
Tax laws continue to dictate how we structure our financial plans. As laws favor or disallow certain strategies, we need to make adjustments. Two examples of this phenomenon are Individual Retirement Accounts (IRAs) and home equity credit-line loans. When everyone was allowed a tax deduction for a Traditional IRA, this strategy was widely encouraged and used. Since tax laws restricted IRA deductions, many people automatically either turn to Roth IRAs or eliminate IRAs completely as a viable alternative. Since tax deductions for non-mortgage consumer interest are not allowed, many people have turned to home equity credit-line loans to finance large purchases and deduct the resulting interest.
As tax laws change, adjust your financial plans to use strategies which are most favorable to your situation. Most of us are aware of the tax advantages of tax-deferred savings. The idea, of course, is to put off paying income taxes on money until you withdraw it in retirement when, possibly, your tax bracket may be lower. However, you have no guarantee that this will happen, especially if you are very successful at saving for retirement and accumulating assets. In addition, the tax laws are constantly changing. You should seek the advice of a Certified Public Accountant (CPA), Certified Financial Planner® (CFP), or tax professional to gain insight into how tax laws will affect you.
For example, under a tax law effective in 1997, up to $250,000 of profit from the sale of a primary residence is tax-free if you file an individual tax return; up to $500,000 if you and your spouse file jointly. To qualify for this tax-free benefit, you must own and live in your home for 2 of the 5 years prior to the sale. Only one spouse is required to own the home, but both need to have lived there to qualify for the larger $500,000 capital-gain tax exclusion. Further, you can use this exclusion even if you previously claimed the old $125,000 exclusion. How often you use this new exclusion is unlimited, but generally you can qualify only once in any 2-year period. If you must sell a home because of ill health, a job-related move, or unforeseen circumstances prior to meeting the 2-year test, you can claim a prorated exclusion [See Internal Revenue Service www.irs.gov].
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