So you quit the corporate rat race to start your own business.  It’s hard work, but you enjoy the freedom and the thrill of being your own boss.  There is nothing that you miss about your old job.

Except maybe your 401(k). 

Traditional and Roth IRAs are nice, but limited as to the amount you’re allowed to contribute each year.  You feel it’s not enough to fully fund your retirement needs.  And you need tax savings now.

Consider the world of small business retirement plans.  There are several plans that are specific or adaptable for small businesses or sole proprietorships.  These include the SIMPLE IRAs, SEP and SARSEP IRAs, and Keogh plans.  Keogh plans (also called HR-10 plans) are qualified plans that include Solo 401(k)s, profit sharing plans, money purchase plans and defined benefit plans.  Each plan has its advantages and disadvantages, and applicability to different business situations.  Each one is highlighted below.

SIMPLE IRA

The SIMPLE IRA (Savings Incentive Match Plan for Employees Individual Retirement Account) is a tax-deferred employer-sponsored retirement plan similar to large 401(k) and 403(b) plans, but with simpler and less costly administration.  The SIMPLE IRA is funded with pre-tax dollars. 

Contributions are currently limited to 100% of net earnings up to an $11,500 maximum ($14,000 for persons over 50).  This is lower than the current limit of $16,500 for traditional 401(k) and 403(b) plans, but more than double that of traditional IRAs. 

Only employers with less than 100 employees may establish SIMPLE IRAs.  After crossing the 100-employee threshold, the SIMPLE may continue for two more years before a different plan must be implemented. 

Employees are not required to make regular contributions, but the plan does require a certain minimum contribution from the employer.  This minimum is either a dollar for dollar match on the first 3% of employee salary, or a flat 2% of salary for each employee with at least $5000 in compensation for the year.

This type of plan would be appropriate for businesses with no employees, or with few employees if you’d like to offer them an incentive to continue to work for you.  The mandatory employer contribution is generally less for a SIMPLE than for a SEP.  If the number of employees is getting close to 100, you may want to consider a traditional corporate retirement plan to save the hassle of having to change it over.

SEP IRA

The SEP IRA (Simplified Employee Pension Individual Retirement Account) is a variation of the IRA.  It has no significant administration costs for self-employed persons with no employees.   

Contributions for the self-employed person is limited to 25% of net earnings from self-employment, or $49,000, whichever is less.  The formula for net earnings from self-employment is all revenues minus expenses minus the deduction for one half of your self-employment tax minus deductions for contributions to the SEP IRA.  (If this sounds convoluted to you, don’t worry; the IRS has a cheat sheet for this calculation.)

If the self-employed person does have employees, the employees must receive the same benefits as the owner (the same percentage rate).  For the employees, the SEP IRA is similar to a traditional IRA only with higher contributions limits and with contributions made by the employer, not the employee.  The IRS maximum restrictions on employee eligibility is be at least 21 years of age, has worked for the employer for at least three of the last five years, and received at least $500 in compensation during the year.  Your plan eligibility may be less strict than this(i.e., younger age, etc.), but not more. 

A SAR-SEP is a variation in which the employee may also contribute a portion of their pre-tax pay.  SAR SEPs are allowed only if the employer has fewer than 25 employees during the prior year.

Similar to a SIMPLE IRA, a SEP IRA would be appropriate for businesses with no employees, or with few employees if you’d like to offer them an incentive to continue to work for you.  The mandatory employer contribution would be higher for a SEP than for a SIMPLE.  Another difference in choosing between a SEP or a SIMPLE IRA is in the amount of net earnings from self-employment.  The pivot point is $46,000.  Using the SEP calculation, 25% of $46,000 is $11,500 – the maximum contribution for the SIMPLE.  At less than $46,000, a SEP actually would allow a maximum contribution that is less than what would be allowed in a SIMPLE.  So for a self-employed person with no employees, and with net earnings from self-employment above $46,000, a SEP IRA would be a wise choice; otherwise, use a SIMPLE IRA.

Keogh Plans

Also called HR-10 plans, these are considered qualified plans for tax purposes.  These include Solo 401(k)s, profit sharing plans, money purchase pension plans, and defined benefit plans

Solo 401(k)

Similar to a corporate 401(k), a Solo 401(k) offers tax-deferred savings for business owners.  The business must be very small, limited to the business owners and their spouses.  It also works for partnerships, including partners’ spouses.  You may have part-time employees who work less than 1,000 per year; they will be excluded from the plan.  If you have an employee that works more than that, you can’t do a Solo 401(k)

Financial Aid Options

Parents and students who do not have the financial resources to pay for college themselves may pursue other options for educational funding.  These include scholarships, grants and loans, plus several other options you may not have thought of.

Scholarships

Scholarships are free money.  They do not need to be repaid.  Most are awarded on merit, be it academic, athletic, or other skill or talent.  Some are based on need or disadvantage.  Others are based on connection to an organization.  They are offered by the federal government, some states, the college or university in question, and public and private organizations (which can be for-profit companies or non-profit institutions).  There are literally hundreds of different scholarships that are available, waiting to be tapped.  You just have to find them.   A book or reference guide on the subject can help you with this endeavor.

Grants

Grants are also free money, offered by the same groups as scholarships.  These are generally based on need or disadvantage.  The most widely known grant program is the Pell Grant.

The Pell Grant is a federally funded program.  Millions of dollars are awarded each year on the basis of need.  Most go to households whose incomes are below $50,000 per year.  Pell grants are only available for undergraduate studies, except for post-baccalaureate teacher certification in some cases.  Only one per student is granted per year.  The amount awarded depends on need and costs, whether or not the student is full-time or part-time, and whether or not the student attends the full academic year or only part of it.  It is also determined by the federal budget and the size of the applicant pool, making this grant a relatively undependable source of college funding.

Another grant is the Federal Supplemental Educational Opportunity Grant (FSEOGS).  This grant is for undergraduates who demonstrate exceptional need.  The amount ranges annually from $100 to $4000.  It can be awarded in addition to the Pell Grant.

Loans

Loans are offered by the federal government, some states, and banks.  The federal government may subsidize certain student loans if financial need is demonstrated.

Stafford loans are available for undergraduate and graduate studies.  These loans can be subsidized or unsubsidized, and have maximum amount limits.  Stafford loans have fixed interest rates, and loan proceeds are paid directly to the school.  The student must attend at least part-time.  Subsidized Stafford student loans used to be available through a variety of institutions, but as of July 1, 2010, they are offered only through the federal government.

Subsidized Stafford loans offer a slightly lower interest rate than unsubsidized loans.  Interest does not accrue while the student is in school and during the deferment period.  Payment can be deferred until up to six months after leaving school.  Subsidized loans are based on need and require a FAFSA.

Unsubsidized Stafford loans are available to any student regardless of need.  Interest accrues from the date disbursed, but payments can be deferred while enrolled.  This increases the size and cost of the loan.

The Federal Perkins loan program is available for undergraduate and graduate studies.  This low interest loan is granted by the college or university and reimbursed by the federal government.  This loan is given based on need.  All or part of the loan may be forgiven for certain public, military, or teaching service.

A PLUS loan is a student loan offered to parents of students enrolled at least part-time at eligible institutions.  Interest is fixed at 7.9% (higher than for Stafford loans) for the life of the loan, and begins to accrue from the date of first disbursement.  Repayment plans can vary.  Repayment begins 60 days after the final disbursement, or can be deferred until six months after the student ceases to be enrolled at least half-time.  PLUS loans can be obtained for amounts that cover up to the entire cost of education, including living expenses, less other financial aid.  A PLUS loan is a commitment of the parent, not the student.  Parent must have a good credit history to be eligible.  A PLUS loan is also available to graduate and professional students directly; in this case, the student is responsible for repayment and must have his/her own good credit history.

Private student loans are available through banks and other commercial financial institutions.  Rates, amounts and eligibility criteria can vary.

Work Study

The federal work study program offers part-time work on campus for compensation that is applied towards college expenses.  The compensation paid out by the school is reimbursed by the federal government.  Total payments cannot exceed the size of the federal grant to the school.

Direct Aid from Colleges

Colleges and universities often have their own budgets for scholarships and other aid, often provided by alumni gifts and endowments.  Criteria for award and amounts vary by school.

Armed Forces

Examples of funding sources available through the armed forces include the GI Bill, ROTC scholarships, and Congressional appointments to a military academy.  These require a specified term of service.

Employers

Employer sponsored scholarships are awarded to dependents of the employee.  For the employee himself/herself, employers may provide up to $5250 per year reimbursement for employee educational expenses not related to the employee’s job function.  This reimbursement is not reportable as income to the employee.

Applying for Financial Aid

For many financial aid programs, families need to complete the FAFSA form (Free Application for Federal Student Aid).  This form should be completed as early in the tax year as possible, and needs to be submitted to the U.S. Department of Education.  After review, the department issues and SAR (Student Aid Report) and copy of the EFC (Expected Family Contribution) to each school listed on the FAFSA.

The EFC is the amount the family and student are expected to personally contribute towards the cost of higher education.  The EFC measures family financial strength, and is used to determine the eligibility for federal student aid.  Based on a 1965 formula, financial aid need equals cost minus EFC.

Personal Funding

There are several options available for parents or other individuals to personally pay for a student’s college education, either in whole or in part (the expected family contribution).  Tax treatment differs for each option, and should be carefully evaluated to determine the best option(s).

Private Investment Accounts

Private investment accounts are typically the least tax efficient option for funding education.  The advantages include no maximum on the amount contributed, absolute control over use, and unlimited flexibility in how assets are managed.  However, with each disbursement, earnings and capital gains taxes are realized.  This disadvantage with private accounts is often larger than the disadvantages of lower flexibility, contribution limits and control of assets of other options.

Custodial Accounts (UTMA/UGMA)

Custodial accounts allow minors to have assets titled in their name but managed by an adult (the custodian) until age 18 or 21, depending on the state.  At the age of majority, the child gains full control of the assets.  The advantages are that the custodian maintains full control until the child reaches the age of majority, and earnings generally get more favorable tax treatment than parents’ private accounts.

At the age of majority, however, the child assumes full control of both the investment decisions and the disbursements.  The child can choose how to spend the money – either on college (as earmarked by the donor) or on anything else the child wishes.  Also once set up, the parent cannot give assets to another child.

Contributions to a custodial account are considered gifts and are therefore subject to gift tax rules involving maximum limits to avoid the gift tax.  If the donor and the custodian are the same person, the donor/custodian is considered to have sufficient control over the assets so as to have the assets included in the custodian’s estate until the student’s age of majority.

Coverdell Education Savings Accounts (ESAs)

Coverdell ESAs operate much like IRAs in terms of tax-deferred treatment; however the maximum contribution per year is currently limited to $2000 per year.  Earnings are exempt from taxes if used for qualified educational distributions; therefore, earnings grow faster than in private accounts.  Qualified distributions include expenses for primary, secondary and higher education.  Individuals direct the investments.  All assets must be distributed by 30 days after the student reaches age 30.  Participation is limited based on income; higher income earners are not able to use this type of account for education savings.

529 Plans

529 plans are another alternative for tax-advantaged savings, and are the most popular.  Set up by states, 529s offer higher contribution limits, and greater donor control over the assets.  There are no adjusted income limits.  However, if allowed by income, savers can do both the 529 and the Coverdell.

There are two basic types of 529 plans.  The first are 529 savings plans.  In these plans the contributor makes contributions and selects investments from those offered within the plan.  The donor takes on the investment risk as to whether or not there will be enough money to pay for school.  The second type is prepaid tuition plans.  In these plans the contributor makes contributions to cover future higher education expenses.  Amounts are determined by a number of factors, and there are no investment options to choose from.  In this case, the school/state takes on the investment risk.  If the student attends an in-state public school, he or she does not have to worry if there will be enough money to pay for college.

In either plan, sponsorship is limited to eligible state programs and eligible private institutions.  They can be set up by the state/state agency or by the educational institution.  States offer savings plans or prepaid tuition plans.  Schools only offer prepaid tuition plans.

Contributors may be family members or non-family.  Contributors are able to change the beneficiary, but only to another family member of the beneficiary (prepaid plans may adjust the premium in this case).

Students must be enrolled at least half-term.  Eligible institutions include most colleges, universities, community colleges, vocational schools, and even some foreign institutions.

Contributions are made in cash.  This prevents attempts to avoid capital gains taxes by contributing appreciated assets.  In the case of 529 savings plans, rollovers are allowed from other 529 savings plans, UTMA/UGMA and Coverdell accounts, or certain US savings bonds issued after 1989.

Contributors are allowed to invest in a 529 savings plan from most any state regardless of the state in which the student resides (some states do restrict this).  However, it may be of some tax benefit to choose the plan in the home state. The contributor would need to compare the tax benefit of the home state’s plan with the investment opportunities available in another state’s plan.

Contributors are not allowed to individually direct investments outside of the choices available within the plan.  Assets cannot be used as collateral to secure a loan.  Plan contributions are limited to the cost of five years at the most expensive schools in the U.S.

There are several advantages to these plans.  Investment earnings are tax deferred, accelerating growth potential.  Qualified distributions are not taxed.  In some states contributions are tax deductible.  Contributors are able to take advantage of accelerated gift tax treatment, which equates of tax free transfers in one year up to the annual gift tax limit times five.

If withdrawals are not used for qualified educational expenses – tuition, fees, books, supplies, equipment, or room and board – earnings will be subject to ordinary income taxes plus an extra 10 percent penalty.  An exception to the penalty only is made in the event of death or disability of the beneficiary or receipt of a scholarship; ordinary income taxes still apply on the amount withdrawn.  In the case of a scholarship, this penalty exception only applies to the amount of the scholarship.

For prepaid tuition plans, the contract is purchased for a specific price, which defines the specific costs for a specific student.  These plans may guarantee to pay tuition and fees at in-state public schools.  For out-of-state or private schools, these plans typically pay the average of in-state public tuition; the family must make up the difference.  When the student starts school, the plan pays out at the level required at that time.

Prepaid contract expected contributions are based on a number of factors:  current cost of in-state public school tuition and fees; age of prospective student; number of years of education to be purchased; time period over which contract will be paid (i.e., lump sum or 10-year installments, etc.); and actuarial assumptions on how much tuition and fees will be in the future and future return on investments.

Series EE Government Bonds

These bonds are issued at half of the face value.  Interest accrues each year until maturity.  Interest can be partially or fully federal tax-free when used to pay qualified higher education expenses in year of maturity.  Bond prices range from $50 to $10,000.

Use of Series EE bonds have certain requirements. The purchaser must be 24 years old on first day of the month purchased.  Bonds must be registered in one or both parents’ names.  Married parents must file jointly.  Deductibility is phased out for higher adjusted incomes.  Both principal and interest must be used for qualified expenses.

Trust Accounts

Instead of a custodial account, a 2503(c) trust can be established to pay for educational expenses.  The trust is irrevocable once funded.  The student is entitled to the principal at age of majority.  Income can be retained or distributed; if distributed, amounts are taxed at the child’s tax rate, and is therefore subject to the “kiddie” tax. Contributions qualify for the annual gift tax exclusion.

IRAs and other Parental Retirement Plans

Yes, it is possible to sacrifice your own personal retirement needs to send your kids off to school in style.  While you certainly would not use funds truly earmarked for your own retirement, you might consider opening an IRA for yourself that you personally designate as a college fund.  Remember, this is in addition to what you are saving for your retirement.  For employer-sponsored 401(k) and other retirement plans, loans and distributions are allowed for educational expenses.

Both traditional and Roth IRAs can be used for this purpose.  All IRA/Roth rules apply.  However, for a traditional IRA, amounts used for qualified high education expenses are exempt from the 10 percent early withdrawal penalty; ordinary income taxes on the full amount withdrawn still apply.  For a Roth IRA, such expenses are also exempt from the 10 percent early withdrawal penalty.  Ordinary income taxes are paid on earnings only.

Impact of Personal Funding on Financial Aid

Some forms of personal savings can impact the eligibility for financial aid.  Whole books are written on this subject of how the FAFSA form gets evaluated, and we recommend that you take advantage of these resources.   Here are a few major items to keep in mind, though:

Ownership of the assets has a great impact on the level of financial aid that gets awarded.  Generally, it is better to have assets listed in the parent(s) names, as the expected contribution is calculated lower for parental assets than for student assets.  The advantage of putting assets in the student’s name is to take advantage of the student’s lower tax bracket.  However, this generally does not compensate for the amount of potential financial aid lost in doing this.  Also, when the assets are in the student’s name, they have discretion on how the money is spent, and it may not be for education.

Retirement funds, pensions, tax-deferred annuities and life insurance are not considered assets in the need-based formulas.  However, this exclusion only counts for contributions/premiums made before the base year (year of evaluation/first enrollment).  Small businesses owned and controlled by the family are also excluded.

The only debt that counts in the needs analysis is debt secured by property; credit card debt is not included.  So if you owe a lot on credit cards, it would behoove you to pay it down to protect your cash flow once you are paying for college.

Custodial versions of 529 savings plans, prepaid tuition plans and Coverdell education savings accounts are disregarded if the student can be claimed as a dependent.

If you are saving money for a big dollar purchase, make that purchase before submitting the FAFSA.  Otherwise, that savings must be reported on the form, and it is assumed that money will be used to help pay for college.  Related to this, student assets should be spent before spending parental assets.  So when sending Junior off to college and he needs a vehicle, let him buy his own car.

Income Tax Benefits

There are several tax credits or deductions that may be available when using personal funding to pay for college.  The American Opportunity Tax Credit applies to 100 percent of qualified tuition, fees and course materials for self or a dependant, up to a maximum of $2500 per student (up to $2000 plus 25 percent of the next $2000).  The student must attend at least half-time.  This tax credit can only be claimed for the first four years of higher educational expenses.  Other credits or deductions cannot be claimed in the same year.  This credit is phased out for higher adjusted income levels.

The Lifetime Learning Credit applies to qualified expenses at qualified schools for at least part-time studies to improve or upgrade job skills.  This credit is limited to a maximum of $2000 per family (20 percent of the first $10,000).  This cannot be claimed with others in the same year, and is phased out beyond certain income levels.

Interest paid on private or government-sponsored student loans are deductible from gross income to a maximum of $2500.  This deduction is phased out beyond certain income levels.

Calculating College Costs for Personal Funding

There are several steps to calculating college costs.   But first you need to identify several pieces of information.

Information Needed

The first piece is to determine what scale of college you’d like to fund.  Do you want to send Juniorette to an Ivy League school, or will the local community college suffice?  What about a state school versus private college?  In-state versus out-of-state?  The cost per year can vary widely depending on your preferences.

Current costs for the preferred type of college are easy to obtain.  You then need to make some assumptions as to how much those costs are likely to increase each year.  The usual college cost inflation rate used is 6 percent.

The next piece is to identify how long you have until funds are needed, and how many years you’d like to fund.  Age of the beneficiary answers the first question.  The second involves whether or not you want to pay for just an undergraduate education, or if you’re willing to pay for a masters or professional degree.

The fourth piece is to determine how much you can afford to save, and how much you have saved already.  This is a budget function. You may or may not be able to save the full amount you’d like to save.  You also need to incorporate the current value of any assets already saved, and to estimate an annual return on assets.

The fifth piece is to consider what kind and what level of financial aid you expect Juniorette to receive.  Expected financial aid would reduce the amount you would need to personally save.  As stated before, some forms of personal savings can impact financial aid eligibility, and you would need to carefully take this into account in determining where to put your money.

The Actual Calculation

All this information is used in the actual calculation.  The first step of this calculation is to determine the first year of college costs in the year of enrollment, based on the value of the cost at the time of enrollment adjusted by the annual cost inflation rate between now and then.

The second step is to determine the amount of capital needed to fund the number of years of college.  This step uses the amount obtained in step one and an adjusted rate of return that incorporates the estimated investment return and the expected cost growth rate.

If any assets are already accumulated, we then solve for the future value of those assets for the year those assets are needed.  This amount is subtracted from the amount obtained in the second step to determine the net amount needed to save.

The last step determines the savings needed now to pay for these future costs.  The calculation can be solved for a lump sum amount to be invested, or for a monthly savings program.

A good financial advisor would be able to help you with these calculations.

Conclusion

College is an expensive endeavor, and it becomes more and more expensive each year.  However, with careful planning, you’ll be able to send your child to college without sweating, at least about the paying for it part.  You will still need to nag about grades and extra-curricular activities.  Sorry about that, and good luck!

However, all advisors are not the same. So, how do you pick one? Below are five factors to take into consideration when making your choice.

CHOOSE AN ADVISOR WITH FIDUCIARY RESPONSIBILITY

Make sure the advisor accepts “Fiduciary Responsibility” in writing. Fiduciary duty separates a financial advisor from a broker, who is held to a lesser ‘suitability’ standard. Fiduciary requires an advisor to put each client’s interest first and disclose any possible conflicts of interest. While a non-fiduciary advisor may have your best interest at heart, his or her tool box of investment choices is littered with products that may not be the best available.

FEE ONLY OR HOURLY COMPENSATION

Would you want to go to a doctor who gets paid by the drug companies? Essentially, that is what can happen if you work with a broker. Brokers are paid through the products they sell. A fee-only advisor has no incentive other than to search for the best investments. The amount that you pay the advisor will vary. Most fee only firms will charge a percentage of assets that they manage. This percentage varies from 0.25% to 1.5%, depending on the services offered. Some firms will work for an hourly rate.

TAKE CUSTODY OF YOUR ASSETS

Never write a check with funds intended for investments directly to an advisor or his or her firm. You should be depositing your investments into a third party custodian such as TD Ameritrade, Fidelity or Charles Schwab. You are essentially hiring the independent advisor to manage the account. This system creates checks and balances, reducing your chance of fraud.

CHOOSE A COMPREHENSIVE ADVISOR

If possible, choose an advisor who offers tax preparation and estate planning services in addition to financial planning and management. Advisors with a complete understanding of the tax implications to their investing strategy and your individual tax situation will save you money in the long term. In addition to tax planning and preparation, working with a firm that understands and offers estate-planning strategies will help you with the big picture. For example, if your assets are over the death tax exclusion when you die, your estate could be taxed at 55%. The bottom line is that if you hear “consult your tax advisor” or “consult your attorney,” you may consider looking for a firm that offers all three.

DO AN ADVISOR BACKGROUND CHECK

In Georgia, just about anyone can hang out a sign that says “financial advisor.” Make sure to look into the advisor’s background. Does the advisor have a finance, economics or accounting degree? Does he/she have any financial designations? (The CFP® designation is important if the advisor comes from a non-financial background, however it does not guarantee anything other than that they studied the core principles of financial planning.)

You can research independent advisors through the following link:

www.sec.gov/answers/iapd.htm

[Independent fee-only advisors cannot be found at a transaction-driven organization such as a brokerage firm or a bank, which depends on volume and not necessarily relationships when it comes to investing. Independent Advisors often own their own firms and are considered “Investment Advisor Representatives” (IAR) of their firms, which are registered as “Registered Investment Advisors” (RIA) with the State of Georgia or the SEC.]

Hopefully, these guidelines will help you choose a financial advisor whom you can trust and best meets your investing needs.

CASEY TYLER SMITH

Casey Smith is President of Marietta-based Wiser Wealth Management, Inc, a fiduciary fee-only investment advisory firm offering investment management, tax planning-preparation, and estate planning. www.wiserinvestor.com

To clarify, there is nothing wrong with selling products; many salesman have become successful by being honest when others are not and by giving honest opinions even when it means they don’t get the business.

However, would you see a cancer doctor who was only compensated by selling drugs by certain drug manufacturers?  Would you hire a lawyer that was selling something?

So, why would we seek investment advice from those whose main source of revenue comes from selling mutual funds, annuities and stock trades? This happens all the time, under the guise of “Financial Advisor.”

Not all Brokers take advantage of clients; they usually just do not have the freedom not to.

Trading Tips

A while back on the Front page of the Wall Street Journal was an article uncovering some disturbing practices by Goldman Sachs. Goldman Sachs has been sending out written research reports by their analysts to thousands of their clients, all the while holding weekly analyst conference calls with select clients called the “trading huddle.” During these conference calls, analysts give their true opinions about company stocks, the overall market and which stocks are likely to rise in value over the short run. Often these conference calls go against the written reports.

There is also an example given that after one day after the Janus Capital Group, Inc was given a neutral rating, research analysts called 50 of the firm’s selected clients to tell them the stock was likely to move higher. Unfortunately, news leaks out like this all the time, where unethical practices take advantage of clients to the gain of the company.

Other major brokerage houses do the same thing; however, they disclose that they may give advice to premium-paying clients that differs from the written reports.

T.V. Selling

When you watch interviews with CEOs and leading market strategists, they explain with great enthusiasm what they are doing for their clients-today. To be clear, chief strategists and research analysts are hired by large security firms to sell advice to clients in order to generate income through the trading of stocks and bonds.

Something that drove this home for me was watching a guest host-a chief strategist for some well-known securities firm one day, say in a very long winded speech that he agreed with others at the table that traders should raise their cash allocations, but should do so by taking a short position in their stocks equal to their long position in order to quickly reenter the market when they became more bullish.  If you’re confused about this, know that I am too.

Close to Home

We use TD Ameritrade to hold all our client’s assets and also use them to execute transactions for us. TD Ameritrade is responsible for a large percentage of daily trading on the US stock exchanges. They have two main “sides” to the business: retail and institutional. Retail is a place for individuals to keep traditional and Roth IRAs or to have a regular trading account. Institutional is for professional money managers to keep assets there; this is called a custodial relationship. The institutional side has many features and functions retail investors do not have access to.

The main difference between the two sides is that the retail side of individuals is flooded with reports and features for the technical, frequently trading, active investor. On the institutional side, there is no such push or functionality for this kind of charting. Why? Because most professionals who do not receive compensation for trades do not invest clients’ assets in this way.

Most independent money management firms invest with a long term outlook.  This is true of most pension consulting groups, endowments, bank trusts, mutual funds and financial journalists.

The reason for this difference is because TD Ameritrade receives a very reasonable $9.99 per trade.

What It Comes Down To

The problem with financial advice comes down to this fact: advice should be paid for separately from products and products should not pay the advice giver. And guess what, the overall cost of paying for independent advice will most certainly cost less than the expensive products being sold to you.

An industry word we throw around a lot called fiduciary is the difference here.  Doctors, lawyers and even real estate agents have this same standard. Fiduciary means to act on someone else’s behalf; simply put, to act in a person’s best interest. Brokerage houses have a lot of power in lobbying to Washington and have thus far kept themselves out of being fiduciaries to clients.

What most independent, fee-only, Registered Investment Advisors see as the largest problem, is that the general public and many politicians see brokers and Registered Investment Advisors the same. Brokers, for years now, have put “Financial Advisor” on the business cards and in their titles. Titles like financial advisor and financial planner blur the lines between the two. All major brokerage houses run commercials that further blur the lines. Many people, now, are not even aware that there is anything else.

Many clients that come to us from Brokerage houses are confused when we plainly disclose the predetermined fees we bill them each quarter. This is because when you work with “financial advisors” or brokers, fees are hidden and reported as decrease in return. In this way, “financial advisors” can charge you fees no one would agree to if they knew. This is how not even the most honest, most genuine financial advisor could possibly serve the best interest of their clients.

ABOUT WISER WEALTH MANAGEMENT. INC

Wiser Wealth Management, Inc is a private fee only investment firm located in Marietta, Georgia on the Historic Square. As a Fee Only investment firm we do not receive commissions from any financial products. Wiser Wealth Management is a registered investment advisory firm licensed in the State of Georgia, as such, we have a fiduciary responsibility to act in the best interest of our clients.

FIDUCIARY

Fiduciary responsibility is what sets Wiser Wealth Management, apart from other advisors. This mandates that Wiser Wealth Management…

• Finds the most efficient and cost effective investment options
• Acts prudently in the client’s best interest
• In contrast, brokers are not held to the same standards

OUR INVESTING PHILOSOPHY

• Maintain a Diversified Portfolio
• Keep the cost of investing low
• Always invest for the long term

DIVERSIFICATION

Through DIVERSIFICATION an investor can REDUCE 1 of the 2 kinds of investing RISK

1. Systematic risk is the risk of the entire world stock market and can not be reduced
2. Non-systematic risk (business risk), is the risk of owning individual securities. This risk can be eliminated through diversification

Examples of business risk: Enron’s bankruptcy, World Com’s accounting fraud, Overpriced tech stocks during the technology bubble, etc.

Wiser Wealth Management believes proper diversification is obtained by allocating assets across many different asset classes. Optimizing the type of funds in a portfolio is essential to reducing risk. This is why at Wiser Wealth Management we create our portfolios to capture the entire world market. The most effective way to gain exposure to market diversification is through index funds via exchange traded funds.

WHAT IS AN INDEX?

An index is a basket of securities that represents a segment of the stock market. For example:

The S&P 500 represents the 500 largest companies in the United States

The MSCI EAFE Index is a foreign index that holds companies incorporated in Europe, Australia, and the Far East, totaling over 1,400 securities.

WHY INDEX?

A recent study shows that between 1975 and 2006, 99% of active Domestic US Mutual Fund Managers failed to beat the S&P 500.* Indexing removes human behavior, inaccurate market timing and poor stock picking which leads to the under performing of fund managers.Through indexing we can obtain less business risk through diversification and higher returns from lower cost.

*False Discoveries in Mutual Funds: Measuring Luck in Estimated Alphas   University of Maryand-Robert H. Smith School of Business

INDEXING THROUGH EXCHANGE TRADED FUNDS (ETFs)

An ETF (Exchange Trade Fund) is an investment vehicle that allows investors to invest directly into an index, at a much lower cost than traditional mutual funds. Since 1993, the ETF industry has responded to the incompetence of active fund managers and the limitations of index mutual funds. ETFs have experienced tremendous growth in assets under management compared to mutual funds since their introduction in 1993.

MAJOR DIFFERENCES BETWEEN MUTUAL FUNDS & ETF’S

Mutual Funds are traded at NAV (Net Asset Value) after market close and only have to report their holdings quarterly. ETF’s trade during market hours just like a stock and their holdings are reported virtually real time. Mutual Funds depend on a fund manager to pick stocks, where an ETF simply purchases and holds the stock in its assigned index. The average cost of an ETF is .50% where the Mutual Fund average is 1.5%.

WHAT MUTUAL FUNDS DON’T TELL YOU!

Mutual Funds incur additional unreported fees from trading securities in the market place. These transactions are deducted from the funds master account.

HOW MUCH DOES THIS COST YOU?

It depends on the turnover rate of the fund. For example if a fund manager turns over the securities in the portfolio 100% during the year, this means he never held a security for more than 12 months. 100% in turnover can equal roughly 1.0% in additional fees. A 25% turnover ratio will equal .25% in additional fees as would a 300% turnover ratio cost an investor 3% in more fees. In contrast, Exchange Traded Funds usually have no to very little turnover, making your cost much lower.*

*”Mutual Funds: Risk Without Reward” Personalfund.com

WHAT DOES AN INDEX PORTFOLIO LOOK LIKE?

Here is a sample of our Moderate Risk portfolio:

• Short Term Government Bond Index
• Barclays Aggregate Bond Index
• High Yield Bond Index
• Emerging Market Bond Index
• S&P 500 Index (Large Companies)
• S&P 400 Index (Mid Size Companies)
• S&P 600 Index (Small Companies)
• International Treasury Bond Index
• MSCI Europe Australia Far East International Index
• Emerging Markets
• Dow Jones Commodity Index

DIVERSIFICATION THROUGH INDEXING WINS!

This Moderate Portfolio has a annualized 9.5 year rate of return of 8%. In Contrast the S&P 500 has had an annualized rate of return of 1.5% over the same period.

* Return calculated from January 1999 to July 2008

INDEXING IS FOR INCOME INVESTING TOO

Most financial institutions will place you in expensive annuities, undiversified bond holdings or mutual funds to achieve income. Wiser Wealth Management purchases indexes holding High yield stock, bonds, REIT’S, and or Preferred Stock, creating income for those in search of diversification and regularly scheduled withdrawals.

WISER INVESTING

Indexing is certainly not as thrilling as picking a stock your friend or colleague said is the next Google, but in the long run academic and professional research shows us that diversification and a long term time horizon wins the race.

IF I INDEX, AM I JUST GOING TO BE AVERAGE?

We use an indexing strategy because history tells us it performs better than stock picking and market timing over the long term. We invest in indexes across many different asset classes. This allows us to either track the S&P 500 with less risk, or beat the S&P 500 over the long run with the same amount of risk. If you only buy the S&P 500 index, you will just be average, but the average is what the mutual fund managers can’t seem to consistently beat over the long term.

Remember: Keep Cost Low, Stay Diversified, and Invest For the Long Term.

Wiser Wealth Management has a fiduciary responsibility to act in the best interest of its clients at all times. Brokerage firms generally are not fiduciaries to their clients and therefore may not make decisions that are solely in their clients best interest.

Wiser Wealth Management provides its clients with a Form ADV that describes exactly how we do business and obtains our clients consent to any conflicts of interest that may exist in our business. Brokerage firms are not required to provide clients with any comparable type of disclosure.

Wiser Wealth Management charges our clients a fee negotiated in advance and cannot earn any other profits from their clients without the clients’ prior consent. We charge an asset-based fee, so that our interest are aligned with our clients. Brokerage firms’ revenues may increase even if the customers’ assets shrink.

Wiser Wealth Management manages money in the best interest of our clients. We do not engage in business activities like investment banking or underwriting, which brokerage firms do. These other businesses may cause a brokerage firm’s interest or attention to focus on other areas of the firm outside of their retail brokerage business and clients

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WHAT ARE THE ADVANTAGES OF WORKING WITH WISER WEALTH MANAGEMENT, INC OVER A BANK OR STOCKBROKER?

Wiser Wealth Management is held to a higher standard than stockbrokers when it comes to putting investors’ interest first and doing the right thing for our clients’ investments. Independent RIA’s have a fiduciary duty to their clients which means we must:

Act in the best interest of our client

Identify and monitor illiquid securities

Employ fair market valuation procedures where appropriate

Observe procedures regarding the allocation of investment opportunities: including new issues and the aggregation of orders

Have policies regarding affiliated broker-dealers and maintenance of brokerage accounts

Disclose all conflicts of interest

Have policies on use of brokerage commissions for research

Have policies regarding directed brokerage, including step-out trades and payment for order flow

Abide by a code of ethics

Stockbrokers are held to suitability obligations on the part of their broker dealer:

Reasonable Basis Suitability – the broker dealer must believe that the recommended security is suitable for any investor

Customer Specific Suitability – the broker dealer must believe that its recommendation is suitable for that particular investor.

Diversification

Diversification when investing is spreading your investments out to eliminate business risk.  Business risk is the risk one company, industry, or sector has.  This does not include the risk of the economy but the risk of a particular business model and the risk from management making poor decisions.  Proper diversification takes this risk away.  The other risk that can not be taken away is market risk.  Market risk is the risk of the overall economy on the stock market.  ‘Cashing out’ of the stock market is a common method of trying to eliminate this risk but the difficulties of forecasting downturns often makes this method hard to act on.  September 2008 showed how hard it is to avoid market risk.  When the giant, Lehman Brothers filed bankruptcy many money market funds’ value dropped below $1.  This means that what people thought of as cash lost value.  A dollar invested in cash became at that time $.98.  If you are following this, you know that a money market fund breaking a dollar is business risk gone badly.  This is a small example, and those holding any insurance or banking stock will know, business risk has been abundant in 2008.

In the past, it was thought that proper diversification could be found in 15 stocks, than it was 30 stocks.  Now, finance books report 50 stocks are needed to supply diversification.  So what does that mean, 50 stocks are needed to gain diversification?  It means that the there is no more additional benefit in adding one more stock.  However, William Bernstein has written about the research done by Burton Malkiel, author of “A Random Walk Down Wall Street.”  In Burton Malkiel’s research he shows that proper diversification requires a lot more than 15 stocks.  Berstein goes further to add that 200 stocks are not enough and that the only way is to hold all the stocks in the stock market.  This may be new to you but in affect, this is called indexing.  He does not provide a recipe for the weightings of all the stocks in the stock market but he is clear that there is no point where adding another stock is not beneficial.  It is clear by looking at all the research that there is the most addition benefit in adding stocks to a portfolio with less than 50 securities, however what this research says is that risk reduction can still be had by having highly diversified portfolio representing all the stocks available.  In affect, this is free and easy risk reduction.

Diversifying Through ETFs

To obtain and build a highly diversified portfolio is very costly for most investors, since they must incur trading costs.  Exchange Traded Funds (ETFs) can solve this problem.  ETFs are like mutual funds, except they make no management decisions, are designed to track an index like the S&P 500 or Russell 1000.  Investors can trade ETFs intraday like stocks.  ETFs can be considered investable indexes.  Investors wanting to use indexing or add an indexing component to their portfolios can utilize the benefits of constructing portfolios or different asset classes.  Building efficient portfolios can be done easily with knowledge of modern portfolio theory and its techniques.

All investments have fluctuations.  Houses, property, oil, and of course stocks and bonds.  We call the amount of variability standard deviation (variance is the square root of standard deviation), remember high school statistics class.  So, we measure the fluctuations of our portfolios and the stock and bond market by standard deviation.

Since all assets have fluctuations, we define more risky assets as having higher fluctuations about the mean or higher standard deviation.  Therefore in highly diversified portfolios, we can minimize the amount of risk of a portfolio by adding assets that have different fluctuations at different times or low statistical correlation.  This is a very simple version of Modern Portfolio Theory (MPT), which Harry Markowitz won a Nobel Prize for and detailed in his book, “Portfolio Selection”.  Using MPT one can ‘optimize’ a portfolio, minimizing risk and maximizing expected return.

This can give a portfolio made of many assets lower risk than each individual asset.