Chapter 17: Managing Money and Finances
This chapter will address budgeting, savings, and investment strategies, debt reduction, record keeping and bookkeeping, and income tax considerations for the self-employed. I have tailored the material for those of you who are independent contractors or consultants living in the U.S. At the end of the chapter you will find a listing of online resources for further information.
Basic Budget Guidelines:
A monthly budget is often the most useful. Use past figures of income and expenses to estimate your monthly budget for the coming year by reviewing your checkbook for the past twelve months. Some expenses and income items are seasonal or irregular like property taxes or dues. Figure their annual amounts and then divide by 12. What we're shooting for is an estimated picture of your future cash flow. It may help to view the Budget Example at this point, not only for a glimpse at a finished budget, but also to see some categories and give you ideas for your own.
Listed below are average percentages per general expense category. They are meant as guidelines and suggested maximums.
Average % of Gross Income
| Housing + Utilities | 25 to 40% |
| Taxes (actual percent) | 20% |
| Transportation + Upkeep | 15% |
| Food | 10% |
| Clothing | 05% |
| Savings | 10% and up |
| Entertainment + Vacations | 05% |
| Debt (credit cards, personal loans) | 05% |
| Other Expenses | 05% and up |
Some expense (and income) items are not easy to figure; food expense is usually one of these. Put down your best estimate; it can always be adjusted later. When you have all income and expense items listed, subtract expenses from income. You should have a positive amount remaining; this is your bottom line and cushion for unforeseen expenses. Your goal is to live below your means. A negative bottom line is a sign that you need to work at reducing your expenses. It is often possible to reduce your living expenses without reducing your standard of living. Here are some things to consider:
If you have mystery cash (don't know what you spent all that money on) try this: Write down a description, the date and the amount of every transaction for three months. After each transaction, indicate if you paid cash, wrote a check or used a credit card. By recording when and what you bought and how you paid for it you will find out how and where you spend money.
Once you have recorded three months spending history, compile the information into a cash flow statement. This will show you where your money is coming from (cash inflow) and where it is going out to (cash outflow).
You Have a Budget, Now What?
Each month compare your actual income and expenses to your budget. Write down the differences between your actual amounts and your budgeted amounts for each category. Monitor your actual vs budget each month to make sure you are sticking to the goals you outlined in your budget.
Create a reward system. Developing a budget and sticking to it does not have to be dull. For example, after you and your family have reached your annual goal, enjoy a night out on the town. This helps your budgeting process to be a combination of hard work and fun.
As one of your regular expense items you should include payments into a savings (or investment) account (otherwise known as paying yourself first). A good minimum savings goal is 10% of your gross income. The importance of this step cannot be stressed enough; given enough time, it can literally bring you financial independence.
A good guideline for knowing when you have enough savings and can begin investing is to ensure you have 3 months worth of living expenses in liquid savings (Bank Account, Money Market Account, or short term CD) if you are a dual income household. You'll want 6 months worth of living expenses if you are the only breadwinner. Once you have your basic savings and have your retirement covered (see the chapter Planning for Retirement), you can invest.
Investments
Once you are living below your means and building up savings; there's the question of what to do with the money to create wealth. The following are some general investment categories in order from least risk to greatest risk.
How the investment categories compare considering both risks and returns.
Unless you're a near expert in finance, Collectibles, Options, and Futures are likely to be too high risk.
Real Estate is a very localized investment with more "negatives" than many realize and often not easy to sell on short notice (illiquid). However, it is - if bought, managed, and sold correctly - a great source of wealth.
Stock is probably the best general category to invest in for long term capital gain. Along with the increased reward potential comes increased downside risk in the short term. However, the risk of negative returns in Stocks or Mutual Funds that invest in Stocks decreases the longer they are held. Stock Mutual Funds are generally safer than individual Stocks because or the diversification and professional management.
Bonds usually have better returns than categories Bank Accounts or Money Market Accounts and provide a good degree of safety. But know that within this one category the range of risk is wide, from Junk Bonds with the highest risk, to US Treasury Bonds with the lowest.
Money Market Accounts, Bank Accounts, and CDs usually have returns that are near the rate of inflation. These are very safe, but also do not afford a good return on your investment in the long run.
Allocating Your Investments
Once committed to investing, you should give top priority to setting your overall asset allocation. Basically, determine what portion of your investment capital should be used in each of three general investment categories: cash, bonds, or stocks (when referring to stocks or bonds, mutual funds that invest in these securities are included). A traditional rule for calculating asset allocation is to subtract your age from the number 110. The result is the percentage of your total investment capital that should be in stocks; the remainder of your portfolio would be divided among the other two categories in proportions dependent on your need for income (bonds) and liquidity (cash). For example, if you are 40 years old: 110 - 40 = 70% of total investment is in stocks; 30% is left to divide between cash and bonds.
I really need to put all of the money I can into savings and retirement and pay off my debt as I can, right? Wrong! It is much better to pay off debt first, even if it means reducing what you put into savings or putting nothing into savings for a period of time. Why? Take a look at the interest rate you pay on your credit cards. If you are lucky you pay less than 18% APR. Look at what the bank gives you in interest on your checking and savings accounts or what the APR is on a one year CD. Chances are good that it will be less than the interest you are being charged on debt. If you put $100 into savings that earns 5% APR, then pay another $100 on a credit card that charges you 12% APR, you are losing 7% on your money. If you put the $100 you put in savings toward the credit card instead, you will pay the card off early, then any savings you have will truly earn you the 5% because you won't have to offset your interest income with interest expense.
Most of us have some credit cards and perhaps a personal loan or two. Credit card debt alone has risen significantly over the last two decades as we have gotten into the unfortunate habit of buying now and paying later. The problem comes when you can't pay later, your debt rises, and you end up spending a small fortune in interest.
Being credit card debt free at the least and totally debt free at the most will save you thousands of dollars in interest over your lifetime. Consider going on a cash basis and putting the credit cards in a drawer.
If you are not in a position of paying off all your credit card balances in full each month, consider the following steps to reduce your debt.
Step 1: Write down all outstanding credit card and loan balances in ascending order (smallest to largest).
Step 2: Concentrate on completely paying off the lowest balance. For example, if the minimum monthly payment is $20 on the smallest balance, a check could be written for $70. ($20 minimum required plus an additional $40). Pay this extra amount every month until the entire balance of the lowest credit card or loan is paid off.
Step 3: Once your lowest balance debt is paid, concentrate on the second lowest balance debt. Add the amount you were paying on the first debt (that is now paid off) to the minimum monthly payment of the second smallest debt. For example, if the payment on the first debt was $70 and the minimum payment for the second card is $55, then your monthly payment to the second debt would increase to $125 ($70 +$55 = $125. No additional money is needed to increase the payments on the second lowest debt. You were already paying the $70 anyway, now you are simply adding it to the next debt to pay it of faster.
Step 4: Repeat Step 3 as needed until your debt is paid off. The amount you are able to pay on each subsequent debt item will increase as you cumulatively add the payments you were making on the previous debt to the payment on the current debt.
Going One Step Further
Some people continue this plan beyond credit cards and personal loans and apply the money they were using to pay off credit card and loans to their car payments and their mortgage payments. If your credit cards and personal loans are paid and you choose this path, I highly recommend you do the following before you start: Take the amount of money you were paying on your debt for one month and blow it on something fun as a reward! Then start on the mortgage and the car loans.
Once you get your debt reduced, the last thing you'll want to do is start charging or getting personal loans again. Consider keeping your credit cards at home so you can't impulsively charge something while you are out. Write checks or use your ATM (debit) card for purchases. If you need to, cash a check for the amount of weekly spending money in your budget each week and when the money is gone, don't buy anything until the following week.
If your debt is out of hand and you are unable to meet even the minimum payments on all of your debt, consider getting some help.
The National Foundation for Consumer Credit offers counseling and debt consolidation services, as does the Consumer Credit Counseling Service. If these two resources don't have what you need, check your local yellow pages for consumer credit agencies in your area. One warning - do not pick an agency that charges a lot of money. Most reputable ones have free counseling and free or very low-cost debt consolidation services.
Record Keeping and Bookkeeping
Well-organized records will make it easier to prepare your tax return and will help you answer questions if your return is selected for examination (the dreaded IRS audit), or if you are billed for additional tax.
Records such as receipts, canceled checks, and other documents that support an item of income or a deduction appearing on your return should be kept until the statute of limitations expires for that return. Usually this is 3 years from the date the return was due or filed, or 2 years from the date the tax was paid, whichever is later. There is no statute of limitations when a return is fraudulent (you would never do that) or when no return is filed.
You should keep some records indefinitely, such as property records. You may need them to prove the amount of gain or loss if the property is sold. Generally, income tax returns should be kept for 3 years. They could help you prepare future tax returns or amend a return. For more information on record keeping requirements for individuals, see IRS Publication 552 Record Keeping for Individuals.
There is no specific method of bookkeeping you must use if you have a business. However, you must use a method that clearly reflects your income and expenses and the records should substantiate your expenses.
The documentation you should keep for each of these expenses can be found in IRS Publication 583, Starting a Business and Keeping Records, and IRS Publication 463, Travel, Entertainment, Gift, and Car Expenses.
Software for Bookkeeping
The most popular software packages for bookkeeping are Quicken, Quickbooks, Quickbooks Pro, and Microsoft Money. If your finances are relatively simple, Quicken or Microsoft Money will work for you. If you need to track cost of goods sold or have subcontractors or invoicing, Quickbooks has more advanced features. If you have payroll, you'll need Quickbooks Pro. Most of these packages now offer online banking via the Internet. To learn more about these software packages, see the following web sites:
Quicken - http://www.quicken.com/
Quickbooks and Quickbooks Pro - http://www.quicken.com/quickbooks/
Microsoft Money - http://microsoft.com/money/
Getting Help with Bookkeeping
If you would rather swim through nuclear waste than deal with keeping books, consider hiring a bookkeeper, accountant, enrolled agent, or CPA to help you. The differences between these professionals is generally one of education, not necessarily ability. Anyone can himself or herself a bookkeeper and no education is required, just experience (you hope). An accountant generally has a bachelor's degree in accounting or finance. An enrolled agent is someone who has taken an IRS test and has the ability to prepare tax returns. No education beyond a high school diploma is required. A CPA has a college degree and has passed a pretty difficult test. A CPA also must meet a continuing education requirement each year to keep the license. The more education and qualifications the person has, the higher the fee.
Decide what your comfort level is and how much you are willing to pay someone. Then make sure to obtain references and get a clear understanding of what the person will do to help you. If you are in business for yourself, it is a good idea to get someone else to prepare your tax return. It is hard to edit your own work when you write. It is similarly hard to check your own bookkeeping. A fresh pair of eyes and an objective mind can be beneficial at tax time.
This section will address some common tax considerations facing independent contractors and consultants.
Home Office
Your home office deduction is figured by multiplying the business percentage times your allowable household expenses. The IRS places a limit on the amount of the deduction (see below).
If your office is only a couple of steps from refrigerator, you may be able to deduct a portion of the operating expenses of your home. To qualify, you must use your home regularly and exclusively as:
Your principal place of business, or
A separate structure at your home (such as a workshop, greenhouse, or studio), or
Where you meet and deal with clients or customers in the normal course of your business
Beginning in 1999, the rules for qualifying relax. Your home office will qualify as your principal place of business for deducting expenses for its use if:
Calculating the Business Percentage
The percentage of your home used for business is computed using the following formula:
Business percentage = Square footage used for business divided by Total square footage of home
Deductible Expenses
Deductible office expenses include rent, real estate taxes, mortgage interest, utilities, home insurance, wages of domestics, and depreciation. If clients or customers regularly visit your home, the costs of lawn care, landscaping, and driveway repairs are also included. A pro rata share of repairs that benefit the entire home, such as roof repairs or painting the outside of the house, may be claimed. The same is true for the business portion of the cost of installing and maintaining a home security system.
Your basis for depreciation is the lower of the fair market value of your home at the time you began using it for business or its adjusted basis (usually purchase price plus cost of improvements). The portion of your basis allocable to land cannot be depreciated. Only the business percentage of the depreciation on the entire house is deductible.
In addition to depreciating your home, you may also depreciate your office furnishings and equipment used in your business. In general, these assets are depreciated using a seven-year recovery period. The amount of depreciation allowed each year is determined by reference to a percentage table.
Limitation on Home Office Deduction
Your total home office deduction cannot exceed the gross income you derive from using the office minus all operating expenses other than home-related expenses (other than those expenses deductible in any event, such as mortgage interest, property taxes, and casualty losses).
Somewhat confusingly, this is called the gross income limitation.
In applying the gross income limitation, you claim home office expenses in the following order:
1. Allocable mortgage interest, property taxes, and casualty losses, if any
2. Operating expenses allocable to office (e.g., insurance, repairs)
3. Depreciation allocable to office
Any unused portion of interest and taxes should be carried over to Schedule A, Itemized Deductions. The amount of depreciation taken is also important in the event you later sell your home.
Home Office Carryover
Any home office deduction left over after reducing the net income of your business to zero may be carried over into future tax years and taken to the extent of the net income (before the home office deduction) from the same business in the carryover year. It does not matter whether the dwelling is still your home in the carryover year.
For full details on the home office deduction, see IRS Publication 587, Business Use of Your Home
Commonly Overlooked Business Expenses
Despite the fact that most people keep a sharp eye out for deductible expenses, it's not uncommon to miss a few. Some overlooked routine deductions include:
Self-employed health care insurance deduction
If you are self-employed and pay for health insurance, the premiums are tax deductible. The self-employed health insurance deduction rate rises as follows:
to 45% for 1998
to 60% in 1999, 2000 and 2001
to 70% in 2002
to 100% in 2003 and after
Amounts and Rate to Note
Mileage Rates: Business travel remains 32.5 cents per mile for the first three months of 1999, then drops to 31 cents per mile for the rest of 1999. Medical care travel remains at 10 cents per mile; moving expenses (traveling) mileage remains at 10 cents per mile; mileage for charitable purposes remains 14 cents per mile.
Personal Exemptions: The personal exemptions deduction increases in 1999 to $2,750 from $2,700.
Standard Deductions: The standard deduction for 1999 is $4,300 for single persons, $7,200 for married persons filing jointly and qualifying widow(er)s, $3,600 for married persons filing separately, and $6,350 for persons filing head of household.
Social Security Wage and Rates: For 1999, the maximum amount of wages subject to the 6.2% social security tax is $72,600, an increase from $68,400 in 1998. The Medicare rate of 1.45% is unchanged. There is no maximum on the wages subject to the Medicare tax.
Other Chapters in This Book
Planning for Retirement
Getting Insurance (this chapter lacks an author at this time)
Finance Related Sites
Microsoft Money Central
Personal Finance - Home Page - Mining Co.
The Dollar Stretcher
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Historical Tables and Charts, Forecasts
Portfolio Account Worldwide
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Dr. Ed Yardeni's Economics Network
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IRS - The Digital Daily
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