Getting financially organized can mean big payoffs, as one of Alan’s clients I’ll call Edward Smith* illustrates. Edward was a man who loved his family and was concerned about what would happen if he died before his wife. He knew his wife, Amanda*, had tender feelings for their children and that she would give up everything she had to make them happy. Edward wanted to plan ahead financially to ensure that their children would not take advantage of Amanda’s benevolent nature after his death. Amanda had never worked outside the home since their marriage in 1962 and he knew she would be ill-prepared to go out and make a living if all their retirement savings were eaten up by his children.
Edward owned a shirt manufacturing company jointly with some of his employees. At his death, the company would be sold to the employees for an agreed amount; Edward’s share was more than ample to keep Amanda financially secure for the rest of her life. Edward wanted the proceeds from his company’s sale to go directly to Amanda. He worked with his attorney and together they formed a plan that included a trust fund. Edward’s bank agreed to be a co-trustee of the fund along with Amanda, and was charged with the responsibility of making certain Amanda was the primary benefactor, with their children as secondary recipients of the trust’s proceeds.
Edward eventually passed away and his company was sold as planned. Proceeds from the sale were transferred to the family trust. Within a year of Edward’s death, Ralph*, one of Edward and Amanda’s sons, graduated from college and began working. His new employer presented to him a business venture that would require a $50,000 investment in order for Ralph to participate. When Ralph went to Amanda for the money, she was excited to help, thinking it would be an easy matter to withdraw the funds and give them to her son so he could get started on the business venture. However, the bank knew it had the responsibility to keep Amanda’s money safe and secure. After analyzing the possibility of Ralph losing this $50,000, the bank used its authority to refuse to give Amanda the money. She was disappointed and her son was furious. Ralph assumed his entire future was going to be lost, so he put pressure on his mother to go back to the bank and ask for the money. After Amanda persisted, the bank finally did consent to release $10,000 to the son. One year later, the business venture Ralph had invested in went belly up and he began working for another firm. The $50,000 “investment” that never was became a family joke.
Thanks to Edward’s strong organization and forethought, he was able to protect the majority of Amanda’s nest egg. Planning ahead can save you and your family heartache and your hard-earned savings. Edward’s actions demonstrate the need to review your current situation and then take action:
Get mentally organized. If you are overwhelmed by all that needs to be done, learn to relax and take one thing at a time.
Learn what financial documents to keep and what to throw away. It’s smart to keep tax documents for at least seven years. Keep receipts and other documents only if you need to prove something — if not, throw them away. This reduces clutter.
Organize the documents you must keep into a simple, yet efficient filing system. Alan and Peter have found that 95 percent of their clients, when asked, do not know where they keep their automobile insurance policy. Organize all your financial papers into an easy-to-use filing system.
Organize investments based on what’s left after taxes. While most people organize their assets based on the risks of that asset, how easily it could be sold, when it could be sold, or on how much the asset is worth, you should organize based on the taxation of an asset. While each individual’s situation may vary according to risk, liquidity, timing and so forth, everyone’s situation is universal when it comes to taxation. All people are subject to tax. Taxation is definable and absolute. The taxes we pay are demanded of us before we do anything else. That’s why organizing finances around what you get to keep after paying taxes is the best way. By doing so, it becomes easier to plan what you need to do because you know what’s absolutely going to be left over. If you organize based on risk, for instance, you may never be quite sure what you have to work with because that risk will always vary. But taxes are sure. By organizing based on taxation, you can know either how to keep taxes to a minimum, thus keeping more of your wealth, or know how much money you will have left after paying taxes so you can feel free to work with what’s left in order to create additional wealth.
Because there are only five ways you can be taxed, assets should be organized based on the following five dimensions of taxation:
Taxed: savings accounts, checking accounts, credit union accounts, reserve funds, etc.
Tax-free: Municipal bonds, Roth IRAs, etc.
Tax-deferred: Defined benefit plans, 401(k)s, IRAs, SEPs, Keoghs, annuities, mutual funds, pensions, etc.
Life Insurance: Life insurance can be taxed in a variety of ways, and most often is not taxed until the benefit is received in cash while you are living. If you die, then the income is tax-free. How you receive the money determines whether it will be taxed or not.
Capital Gains: Real estate, mutual funds, limited partnerships, stocks, precious metals, fine art, commodities, etc.
Organizing your assets based on these five categories will help you find a significant amount of extra money you didn’t know you had because:
- It makes it easier for you to visualize your assets and in terms of what you get to keep for retirement.
- It provides a basis for calculating and projecting the accumulation of your wealth.
- It helps you understand the impact taxes have on your long-term savings and investment programs.
The following example illustrates the importance of organizing based on these five categories.
Suppose you put all your money in a 401(k) program for retirement. This money will grow because you will be able to defer paying taxes on it all those years you are working. However, when you begin withdrawing this money, 100 percent of it (that includes the interest it has accrued) will be subject to income tax. If you organize your assets based on the way they will be taxed and use a forecasting tool, you will be able to play “what if” scenarios with that 401(k) money to see what would happen if you put it somewhere else. “What if” you put this money into a tax-free municipal bond rather than a 401(k) or capital gains account? “What if” you put it into a Roth IRA, or “what if” you invested it elsewhere? By sweeping all the financial elements that will affect this money out to a future date and looking at the results, it becomes easy to test how a financial decision made today will actually impact your future.
Because there are no future decisions, only decisions made today that affect the future, knowing how to organize your assets and predict what will happen to them provides you with valuable knowledge that will let you make much better choices than if you didn’t possess that knowledge.
Create additional wealth by organizing your finances in a manner that will protect your assets from over-taxation and poor decision-making by yourself, spouse, children, or others.