Sunday, January 28, 2007

Debt Repayment: Why Rate doesn't matter.

You seen these ads: "Refinance with 5.05%!" or "Consolidate your debt with a low interest rate of 4.85%." When it comes to paying your debt, interest rates does not matter. What does interest rate really do for you? It just sets the payment. What it really comes down to is how long you are going to be in debt, which in turn determines how much interest you going to pay. The longer you are paying the debt, the more interest you are paying. So, its not the interest rate that matters, its the rate at which you pay.

Take a look at these two people:
Person A
$100,000 loan
$600/month payment
30 years to pay.

Person B
$100,000 loan
$600/month payment
15 years left to pay.

Which person you want to be and why? The obvious answer is Person B because you will be out of debt is 15 years. Keep in mind, both loans are 30 year loans.

Ok, what if the interest rate in Person A is 6% and Person B is 10%? Keeping everything else equal, would you still take Person B? At this point, most people are not sure what to do because they been trained that interest rate is the most important factor when determining a loan, when in fact it should be the least concern. The obvious answer is still Person B because you are still paying $600/month and you will be out of debt in 15 years instead of 30 years.

You are probably thinking why Person B is still better than Person A? Both loans are really 30 year loans. Like many other people, Person A pays his debt once a month, so he will be in debt for 30 years.

But Person B decided that he want to pay his debt every two weeks or bi-weekly. When you pay bi-weekly, you split your monthly payment in half and pay this amount, which is $300, every 2 weeks. This result in an extra month of payment to the year, which all goes to the principal. By lowering your principal, you are getting out of debt quicker. So Person B will be out of debt in 15 years. Even though he has a slightly higher interest rate, he can potentially save tens of thousands of dollars of interest.

Why? As I mention before, its the rate at which you pay that matters the most. You can be like Person A and pay the loan once a month and pay the full total cost of the loan. Or you can be Person B who gets out of debt faster and pay maybe just half of the total cost. Even though his interest rate is slightly higher, his net effective rate is the true interest rate he is paying. Net effective rate = (prepaid cost of the proposed loan divided by original cost) times interest rate proposed loan. You can only get these numbers if the lender shows you various amortization schedule of different payments (a schedule if you pay once a month, a schedule if you pay bi-weekly, a schedule if you add more money toward bi-weekly). The prepaid cost and time you will be in debt will vary between all types of schedule.

For example, lets say you pay bi-weekly and the prepaid cost of the new loan is $100,000 and the original cost of the loan is $200,000. The interest rate of the new loan is 8%. $100,000/$200,000 x 8% = 4%. If you just paid once a month, then the net effective rate will be 8% since you paying for 30 years. But with bi-weekly payment, its 4%.

In conclusion, there are three things you should really be concern with when it comes to repaying your debt:
1) How long are you going to be in debt?
2) How much money are you going to save?
3) And finally, what is the interest rate?

*Please note that all numbers in this post are hypothetical numbers. But the general concept still holds true if you apply it in a real loan to loan comparison.*

Friday, January 26, 2007

The Debt Crisis of the 21st Century

Debt has become a major issue in the beginning of the 21st century. Today it is the year 2007 and only the past 5 years have I begun noticing that debt is becoming more and more problematic. Bankruptcies filing has been all time high, debt amounts continue to grow every year, and home foreclosures are increasing. Ever year, since 2002 bankruptcy filings continue to break a new record. In 2005, 1.8 million people filed for bankruptcy, setting a new record. I don't know how many people filed for 2006. I wonder how can this happen? America is suppose to be the most educated country in the world, and yet many of us make bad decisions or don't know how to say "no" to these so-called professionals who are trying to sell you something.

1) The Mortgage Industry

When the prices of home plumeted after 2001, many Americans started buying homes. The problem was that many people don't know the different types of mortgages out there and I bet most homeowners today really don't know what kind of mortage they have right now. They think its a fix rate mortgage, but if a mortgage specialist look at it, it may be something else. Do you have fix rate mortgage or adjustable rate mortgage or maybe its an interest-only mortgage? You don't know since they all look the same until you get your next statement that shows a larger mortgage payment than usual. When your mortgage payments start to increase, most people can't afford to pay it. According to, adjustable rate mortgages accounts for 11% of all total outstanding mortgage debt (Sept 6 2006). Over the next 5 years, about one million people could lose their homes through foreclosures. Take a look at this, if you are paying $1500/month on a mortgage and then next month your mortgage payment jumped to $1700/month, will you be able to pay for it? What if it increases again to $1900/month? Most people can't afford an increase in mortgage payment. The best way out is maybe to refinance into a fix-rate mortgage. Refinancing is a difficult task for the lender and you may or may not qualify to refinance with them. Plus, there will be fees involved to refinance. Some lenders include the fee within the loan so that you don't have to pay it upfront. So, if you are going to buy a home, buy a home that you can realistically afford and always get a fix-rate mortgage. That way you can manage your finance better without the need to guess what is your next mortgage payment is going to be.

*UPDATE 2-12-2007* According to Realtytrac Inc, foreclosures has increased by 25% in January 2007 over January 2006. Total number of homes that were foreclosed in January 2007 was 130,511.
*UPDATE 3-13-2007* According to CBS Market Watch, in the 4th quarter of 2006, delinquency rates (people falling behind their mortgage payments) increased from 4.67% to 4.97%. Foreclosure rates (people who are force to close their homes) increased from 3.86% to 4.53%.
*UPDATE 4-29-2008* According to Associate Press, number of US homes facing foreclosure jumped 112% in first quarter over 2007. Nationwide, 649,917 homes received at least one foreclosure-related filing in the first three months of the year, up 112 percent from 306,722 during the same period last year, RealtyTrac said.
*March 15, 2010: CBS "60 Minutes" Author Michael Lewis on Wall St's Delusion

2) Credit cards

The first time I got my credit card was at age 18 and it was a joint account with my brother. I rarely used the credit card except when I needed to buy books and supplies for college. My brother paid for it all and I thank him for that. I knew that if you use a credit card, you have to pay it back. Since I didn't have a job, I didn't use it for anything other than for college expenses. But most people are not like me, and so they spend as much as they can or they max it out. Then when they over did it, they see a huge balance on their credit card and so they opt to pay only the minimum, which is usually less than $50. I believe that credit cards brings the "greed" out of people. We are spending freaks. I'm not going to lie. I like to spend too, but I am able to control myself. If I was out of control, I would be buying plasma tvs, the biggest and loudest speakers there is, and the most powerful computers and consoles to play my video games. So, I think credit card is more of a pyschological problem than a financial problem.

Recently, my state started banking awareness week that teach young adults about money such as budgeting, checking and savings accounts, and being responsible on the use of credit cards. Today, the average balance on credit cards nationwide is around $22,000 and it continues to grow.

3) The Solution

If you are like many other Americans, you probably have debt too. Whether its mortgages, student loans, car loans, or credit cards, there are several ways in which you can pay it off. One option is to create a budget worksheet. That way you an evaluate where all your money is going to and which area you can cut or limit your spending on.

A second option is to consolidate all your debt into one payment. Instead of paying to multiple parties, you now pay one bill to one lender. In most cases, your monthly payment is usually lower. What you should do next is use the savings and add it to your principal. For example, lets say you have a mortgage payment of $900/month and credit card payments of around $500/month. You have about 28 years left on your debt payment. That's $1400/month. When you consolidate them, lets assume your new monthly payment will be $1100/month. You saved $300/month, but now you are in debt for another 30 years. Most banks will stop here and let you figure out what to do with the savings. I only know one company that shows you how to get smart with your money and get out of debt sooner. Note: When you consolidate or refinance, interest rate does not matter. Its the rate at which you pay that matters. The larger the loan and the longer it takes you to pay, the more it cost you to pay.

Third option is to start living below your income. That means, don't spend too much. Whatever income you make, save 10-15% of it. By the time you retire, you will be better off than the rest of the country.

Fourth option is to seek professional help if you are unable to control your spending. Spending above your income means that you are not saving anything for your future. If you want to live a happy life when you retire, you better control your spending habits and start saving.

Fifth option is to pay more than minimum amount. That way you are paying off the principal faster.

Sixth option is to utilize some or all the options above and just do it. Don't wait tommorow, or next week, or next month, when then turn to years and years and years and then you forgot about it.

Seventh option is educate yourself of the products and do research about the company. Read all fine prints before signing any documents.

Sunday, January 21, 2007

Endowment Insurance and Modified Endowment

Prior to Tax Reform Act of 1984, there was a growing popularity of purchasing Endowment Insurance. Like other life insurance, the policy will pay the death benefit if the insured dies within the policy period. What makes it different from other life insurance is that it also pays if the insured lives to the end of the policy period. Like Whole Life, Endowment contracts combine the features of equity growth and protection with more emphasis on the build up of equity in the cash value.

Endowment contracts can mature in either two circumstances. It will pay a death benefit if the insured dies within the endowment period OR it will pay the cash value that is equal to the face amount if the insured lives to the endowment date. Therefore, the cash value must be build at an accelerated rate so that by the end of the policy period, the cash value would equal the face value that is payable to the insured.

Let's say that you bought a 10 Year Endowment policy in 1983 with $50,000 coverage. If you die on or before 1993, your beneficiary will receive the $50,000. If you live after 1993, you will receive $50,000 and no longer be covered.

As you can see, this product sounds very good because there is rapid growth of cash value, your cash value grows tax-deferred, and there is possibility of escaping income taxes if the insured dies and the proceeds were paid as a death benefit. But the disadvantages of having this policy is that you need to pay lots of premiums and you will owe income taxes if you live to the endowment date or age.

Let's say you bought an Endowment at age 65 policy with $100,000 policy. Over the life contract, assume you paid a total of $70,000 of premiums into the policy. When you receive the $100,000, the IRS will tax you the difference between what you paid and what you received, which is $30,000.

In 1984, the marketing of Endowment Insurance ended under the 1984 Tax Reform Act. Since the contract placed more emphasis on accumulation of cash value and relatively little emphasis on death protection, the product was viewed more an as investment contract rather than a life insurance policy. The act says that the cash value in a contract can build no faster than to equal to the face value when the insured reaches age 95. If any policy builds cash value more rapidly than this benchmark, it loses most or all of its tax advantages such as tax deferred growth and no income tax on death benefit.


4 years later after the 1984 Tax Reform Act, Congress pass another act in 1988 called Technical and Miscellaneous Revenue Act. This law says that if a policy creates a cash value faster than that of 7-pay Whole Life Policy, then the policy is a Modified Endowment Contract. Whether its Whole Life, Universal Life, or Variable Life, if the cash value grows faster than a 7-Pay Whole Life policy, then any loan or withdrawal must be made with the understanding that taxable dollars comes out first, then the return premium (which are made with after-tax dollars) dollars. Furthermore, there is a 10% penalty in addition to any taxes due on all withdrawals prior to age 59 1/2.

So if you are trying to accelerate the cash value, don't accelerate too much on what it should be in 7 years. For example, if the cash value is suppose to worth $3000 in 7 years, and you put in more premiums to accelerate the growth, your cash value may be worth more than $3000 in 7 years. If it does, your policy is now a Modified Endowment Contract and it will stay that way for life of the contract.

Wednesday, January 17, 2007

Whole Life Insurance - Nonforfeiture Options

If you own a Whole Life policy for awhile now, you may be wondering on how to recover your cash value. Before I go on, please note that nonforfeiture really means "surrender" value.

In one point of time in the life insurance industry, if you did not pay your premiums and fail to pay it by the end of the grace period, your policy will lapse and you would forfeit any equity held in the policy. In response to this problem, many life insurance companies adopted the nonforfeiture option, which means you are allowed to stop paying premiums and not forfeit any of the equity in the policy. In simple terms, you have three options on how you want to surrender your policy. The amount of cash value will be reduced by any loans you have taken out of it, whether directly or indirectly. What I mean by directly is that you made a call to the insurance company that you want to borrow the cash value for whatever reasons. By indirectly, you did not pay your premiums, so the insurance company used your cash value to keep the policy active.

These are three different nonforfeiture options you can take:

1) Cash. Simply put, you surrender the policy and take the cash value. If you choose this option, you will not be able to reinstate your policy.

2) Reduced Paid-Up Insurance. This is where you give up the current face value of your policy and use your cash value to purchase a lower face amount. Your policy may be reinstated to original policy within the given time frame that is stated in the original policy (typically 3-5 years).

3) Extended Term Insurance. This is the default option if you do not choose a nonforfeiture option. This is where the face amount in your policy remains the same, but you use your equity to purchase a term policy. The length of this term is equal to number of years you have paid your premiums. For example, if you purchase a policy at age 30 and stop paying at age 50, your policy will last under 20 years and 350 days. You may reinstate the original policy within a given time frame. This option is usually not available in rated policies, meaning your health, habits, or occupation is deemed high risk.

Ways to purchase a Whole Life policy

With whole life, there are several options in which you can purchase this policy. Though, if you read my argument why term is better, you wouldn't bother with whole life in the first place. But, if you are still going to get Whole Life, here are several ways you can purchase it. Please note: Whatever purchase plan you take, you are covered for life!

1) You can make one lump sum payment, which is called Single Premium. Whatever coverage you choose, you can pay all the premiums in one payment. This is the least popular method since most people don't have over $20,000 in their hands. How much you need to pay is calculated on how long you are expected to live (your life expectancy).

2) You can make installment payments, which are called limited-pay. In this plan, you make payments over a given period of time or until a certain age. Limited-Pay Whole Life policies are commonly referred to in terms of their payment period, such as 20-Pay Life or Life Paid at 60. While your policy is paid up at a specific age, coverage continues for the whole life.

3) The final and most popular payment is paying continuously, which is also known as Straight Life or Continuous Premium. In this plan, you make payments until you death or until age 100, whichever comes first. In Straight Life Whole Life, you are not obligated to continously pay until you die or when you reach age 100. You may skip your premiums at anytime and not forfeit your equity in your policy. This is called nonforfeiture option. You may take the cash value of the policy or perhaps continue the full face value protection of your current policy for a fix period of time. To learn more about nonforfeiture option, click here.

In conclusion: 1) The shorter premium payment period, the higher annual premium. 2) The higher the premium per thousand face amount, the faster growth of cash value.

Monday, January 15, 2007

Universal Life Insurance and Variable Universal Life

Universal life (UL) combines the flexibility of Adjustable Life with the higher earnings potential of Variable Life. Before I break this policy down, lets briefly mention a few of the benefits:
  • UL can imitate any of the traditional insurance products - whole life to term insurance to Endowment at age 95
  • UL is PERMANENT INSURANCE. Even though the protection element of the policy is ALWAYS INCREASING TERM INSURANCE, the contract can provide coverage until death or around age 95
  • As with Adjustable Life, death benefits can be raised (with evidence of insurability) or lowered.
  • As with Variable Whole Life, cash value can grow at a much higher rate of interest, but
  • unlike Variable Whole Life, there is a minimum guaranteed rate of interest.
  • Though policy loans can work just as they do with other cash value policies, it is also possible to make a cash withdrawal (partial surrender) from a UL policy that neither has to be repaid nor requires the payment of interest. Principle comes out first, therefore tax consequences are minimal.
  • Premiums are even more flexible than with Adjustable Life as they can be raised, lower, or even skipped entirely. (known as "Stop and Go" feature).
  • It is possible to structure UL so that the cash value is paid in addition to the death benefit.

This is how UL work. Each time you pay your premiums, your premium is first credited to a fund, which is call the cash value. Soon, the amount of cash value not only reflects how much you paid, but also what the company has earned. In your cash value, there is a guaranteed minimum of interest, which is usually around 4%. There is also a current rate, which reflects what the company is truly earning on the money. These rates will vary with market conditions. Historically, they have range from 5% to 8% in the past few years. As with other cash value policies, cash value grows tax-deferred. From the cash value, the money is taken to pay company expenses such as commission, premium taxes, administrative costs, on a monthly basis. The money is also taken to purchase term insurance, which is always the protection element of a UL policy.

Unlike traditional policies that force what the cash value should be, you can choose how much cash value you want. The more premiums you pay, the greater the cash value will be. The less premiums you pay, the lesser the cash value. When you purchase a UL policy, you are typically quoted two numbers, a minimum premium and a target premium. If you pay the minimum premium, your UL will closely resemble Term insurance. There will be almost no build up of cash value. If you pay the target premium, the policy will function similar to a Whole Life policy. Based upon interest rates guaranteed in the policy, the cash value would equal the face value when you are between the ages of 95 to 100. If you pay more than the target premium, the policy can work similar to an Endowment insurance. Of course, federal laws dictate that cash value cannot build faster than a Seven-Pay Whole Life contract, which means the growth of the cash value cannot be more than what the value of the cash value should be in 7 years. Therefore, you cannot put bunch of money into the policy in attempt to avoid taxes.

As your cash value grows, you may be able to skip your premiums. This doesn't mean you are not paying it directly. Your cash value is used to pay the minimum premium. Depending on how much cash value you have in the policy and the rate at which the money is earning, it is possible to avoid paying the premiums for quite a long time.

You also have death benefit possibilities. You can decrease your coverage anytime and increase your coverage (with proof of insurability). There are two options on how you want your policy to work.

Option 1 or Option A: Your death benefit remains level and the policy can either pay the death benefit or cash value, not both. As time grows, your death benefit remains level, but your cash value grows. As your cash value grows, you are purchasing less and less term insurance to fund your desired death benefit. And this need for less Term insurance comes exactly at the time when Term begins to get expensive. Remember, cash value cannot grow faster than a Seven-Pay Whole Life policy. If you make any cash value withdrawals and you don't pay it back, your death benefit will be reduced. When the cash value nears the value of the face amount, your cash value will raise the death benefit.

Option 2 or Option B: Your death benefit grows as your cash value grows. You don't know how much death benefit you will have at any given time. All you know that the death benefit will be the face amount plus whatever cash value happens to be when you die. The problem with this option is that the cost of Term insurance gets more expensive as you get older. Most policy owners switch from Option 2 to Option 1 because the cost of Term will be simply too expensive.

Unlike whole life insurance, the death benefit and the cash value are kept completely separate. This allows you to see how much you are paying for Term protection and exactly what is earning in your cash value. In many respects, UL was created in response to "buy term and invest the difference." The UL allows the insurance industry to respond, "Okay, buy our Term and invest the difference with us on a tax-deferred basis."


There nothing much to talk about here. It contains almost all the same features of a regular Universal Life except: (1) Your cash value is invested in the market, therefore (2) there is no guarantee interest. Variable Universal Life is considered a security and agents selling this product must have a life license and a securities license.

Here is something you should really take a look at if you have a universal life policy:
Universal life is an increasing term policy where the cost of having insurance increases internally and less premiums goes toward the cash value. For example, lets say you pay initially pay $100/month for a $100,000 coverage. $10 of it goes toward the insurance and $90 goes toward the cash value. Next year, the cost of insurance goes up to $12, and $88 goes toward the cash value. Every year, the cost of the insurance goes up and less premiums goes toward the cash value. Eventually, the cost of insurance will equal to $100 and $0 goes toward the cash value. A year after that, the cost of insurance will be $110 and if you don't pay the extra $10, the $10 will be deducted from the cash value. What if you don't want to pay the new premium? Then $110 will be deducted and premiums will continue to rise.

I had a client who had a universal life policy with $20,000 coverage when the premiums were initially $318/year and 25 years later, it jumped to $383/year. It had about $10,600 in cash value after surrender charges. The policy eventually paid dividends that was enough to cover the premiums. It paid dividends every year for awhile. Eventually, something happened and no dividends were paid out. She didn't pay her premiums, so what happen next is the cash value was automatically used to pay the premiums. When I was about to do a 1035 exchange, I found out that there was a loan balance of around $800. So I had her pay the balance off to avoid taxes and moved the entire $10,600 cash value into a variable annuity. 6 months later, the variable annuity was worth around $11,300 and she didn't make any contributions to it. I'm not going to talk about variable annuities, but the main point is that universal life insurance is not that great as it seems. Don't be fooled when an agent says that policy pays dividends because they are not guaranteed. Plus, the cost of the insurance increases internally. You don't notice it because the premiums remain about the same for awhile. Eventually, your premiums will go up too. If you have a universal life policy, you should check it out yourself.

Thursday, January 11, 2007

Annuities: Payment or Purchase options

There are three ways to buying an annuity. The first would be called single payment immediate. This means you give the insurance company a lump sum of money and within 30 days or so, you will begin receiving these payments for life. This is most suitable for someone who is near retirement or above age 59 1/2.

The second payment option is called Single Payment Deferred Annuity. That means you give a lump sum of money to the insurance company and the company will invest it for you until the time you choose to begin payout. During this time, your investments grow tax deferred. Most lottery winners choose these payment option. And many professional athletes that earns millions of dollars are given a single payment deferred annuity by their team or employers as a form of future compensation.

The third payment option is called Periodic Payment Deferred Annuity. This is most suited for someone who doesn't has a large sum of money. So, they will elect to put money in the annuity on a monthly, quarterly, or annual basis. Many variable annuities require a minimum balance of $5000 or more. If you don't have that kind of money, you can setup a periodic schedule of payments in which you can put in a minimum of around $250/month or so (depending on what the prospectus says).

Annuities Settlement or Payout Options

What are your settlement options (or payout options)? There are several settlement options you can pick. First one is called the straight life annuity. This is the largest monthly payout option of all three. What this option do is that you want to receive monthly payments for life and don't want anyone else to have it in case you die. If you die before your life expectancy, the insurance company retains the balance of the account. If you outlive the life expectancy, then you have receive more money than what was expected to pay out. It's a high risk scenario for you and the insurance company. You hope to live longer than expected and the insurance company hope you die sooner than expected.

Second settlement option is life annuity with period certain. That means if you die during a certain period of time, your beneficiary will receive the rest of the annuity payments until the period ends. For example, if you elected a life annuity with 10 year period certain and you die during the fifth year, the insurance company will continue paying your beneficiary for the next 5 years. Remember, annuities pay you, the owner, for life. So after the tenth year, you will continue to receive payments, but your beneficiary will not in the event of your death. Periods can be as long as 15 years or 20 years in some companies.

The third settlement option is called Joint and Survivor annuity. That means, you will be paid a monthly benefit as long as you live. Upon your death, a predetermined percentage of your monthly payout will continue to be paid to your beneficiary until that person dies. The percentage varies between companies and can be low as 50% or high as 100%. You may be able to negotiate this percentage. The higher the percentage you pick, the lower the monthly payments you will receive. This settlement option has the least risk to you and therfore, has the smallest monthly payment of all three options. "Lower risk = lower rewards. Higher risk = higher rewards."

The forth settlement option is called Lump Sum Settlement Annuity. As it says, you want to take the whole balance of your account in one lump sum. This puts your investments in your hands and you accept all risks on what you plan to do with it. You will avoid the risk of getting less thatn a full return of your invested capital plus earnings. The drawback of receiving a lump sum is that the IRS will know that you have receive large amount of income and this may push you up in a higher tax bracket.

For example lets say the value of your account at the time you taken the lump sum was $150,000. $65,000 of it was from your own contributions and the other $85,000 was from earnings. If you taken the lump sum of $150,000 you will need to report the $85,000 as ordinary income on your 1040 tax form. Depending on what your normal income was, this may put you in a higher tax bracket than you normally were. Most people will not take the lump sum option because they don't know what to do with all the money. They can put it in a bank account, but they will lose the earning power that the money can generate if it were invested in the stock market.

Another payout option is called installments of designated amounts. That means a specified amount is paid every month until the account is exhausted, after which no further payments are paid. Its similar to a mutual fund withdrawal. Another payout option is called investment income, which the principal is left intact and payments only consist of the earnings. At death, the principal amount is paid in one lump to the beneficiary. Both of these payout options benefits the beneficiaries more than the primary annuitant.


What is it and what do you need to know? First, annuities are products created by the insurance industry in response to their clients' needs. What kind of needs? The need to protect against untimely death and the second need of a professional expert in the management of money. With life insurance it can protect your family against untimely death. Insurance is a mean by which an individual manages risk against financial devastation of his/her family when he/she dies during the income earing or working years.

With annuities, it also mean by which an individual can manage risk of living too long and running out of money. Annuities are contracts purchased by an individual in which an insurance company pays out monthly payments to the individual beginning on an agreed-upon date and guarantees the individual the payments will continue no matter how long he lives. In other words, you pick a date in the future in which you want to begin payout and from that time on, you will get paid for life!

Therefore, life insurance protects you against dying too soon and annuities protect you against living too long.

There are three types of annuities. The first type is called fixed annuity. Only thing you need to know about a fixed annuity is that the insurance company GUARANTEES the investor that it will pay him or her a specified, pre-determined amount of monthly payout beginning on an agreed upon date in the future. No matter how the portfolio performs, you are guaranteed a rate of return and the insurance company takes on all the risk on how their investments perform. The problem here is that the market may perform above the fix rate and that you may suffer substantial inflation risk or purchasing power risk. On the plus side, if the market performs badly, you are guaranteed a rate of return. It is therefore, the investor receives no risk in purchasing a fixed annuity, no matter how the market performs.

A variable annuity is a contract where your money will grow at a rate base upon the performance of a specified portfolio o f the insurance company. Your investments are not guaranteed a rate of return, your first monthly payment is pre-determined, after the first payment, your payment will vary depending on the portfolio performance. It has every characteristic of a mutual fund such as breakpoints, letter of intent, and rights of accumulation, except that your investments grow tax-deferred. If you purchased a mutual fund by itself, you will owe annual taxes on it unless you put the mutual fund in tax-deferred accounts such as IRAs. You assume all risk on how your portfolio performs. Therefore, the SEC say that variable annuities are securities and that representative selling this product needs a Series 6 license. Fixed annuities are not securities because the investor is not assuming any risk.

The third type of annuity is called combination annuities. This mixes both variable annuity and fixed annuity together. You will receive a fix amount and a variable amount in attempt to hedge against both inflation (variable side) and deflation (fixed side). This is good for someone who wants growth in his or her account but is concern that the market will go down. How much you want to invest into fixed and variable annuity is up to you. You may put 50% into fixed and 50% into variable, 25% into fixed and 75% into variable, or whatever you are comfortable with.

There are two phases of annuity contract. First phase is called the Accumulation Period. This is the time where you put money into the contract and let it grow tax-deferred. The second phase is called the Annuity Period, which is the time you begin receiving payout.

Since your investments grow tax deferred, if your annuity was part of a retirement plan such as 401k, 403b, IRA, pension plan, etc, you will owe income tax on the entire balance at the time of withdrawal. These plans are known as qualifed plans because your investments were pre-taxed, meaning you didn't pay any taxes on your income yet.

If your annuity was purchase by itself, you will owe income tax only on the earnings. These plans are known as non-qualified plans because your investments were made after-tax dollars, meaning you paid taxes on your income already.

What do fixed annuities and variable annuities have in common?
1) Both accounts grow tax-deferred.
2) Upon withdrawal, only earnings in the account will be taxed. Not your contributions.
3) Both guarantee income for life. This is known as the mortality guarantee.
4) Any early withdrawal before age 59 1/2 will result in a 10% tax penalty.
5) Both are long term investments such as mutual funds.

Common question I hear is how does the insurance company stay in business if they guarantee payments for life? Because for every person who lives beyond their statistical life expectancy, there's a person who doesn't reach that age. So, if you live longer than expected, you are getting paid more than what you are suppose to do. However, if you die sooner than expected, payments will stop.

What if you die during the Accumulation Period? In most variable annuity contracts, they contain a provision that is known as the Death Benefit Provision. That means your beneficiary will receive a death benefit that is guaranteed at least the amount you have put into the account. So, even if your portfolio has done badly and you lost value, your beneficiary will receive a death benefit by the total amount you have put in. If the investment has made some earnings, these earnings will be included in the death benefit. For example, lets say you only put in $10,000 into your annuity. At the time of your death before the payout begin, the value of your account was $20,000. So, your beneficiary will receive $20,000. Your beneficiary will be liable on the taxes that are owed on the earnings, which is $10,000 ($20,000 - $10,000).

If the portfolio perform badly and the value of your account was $8000 at the time of your death, your beneficiary will receive a death benefit of $10,000.

What if you die after the accumulation period (or during the annuity period)? Well, at the time you were filling out the contract with your registered representative, they were several settlement options you can pick. One option is where you keep all the money to yourself. The other options shares your investments to a beneficiary in the event of your death. To view these different settlement options, click here. Please note: When the payment begins, you can not change your settlement option. You are stuck with that decision for life. If you want to change it, you must notify the company within 30-60 days (check your contract for actual time) before the scheduled beginning payment date.

Click here to see your Purchase or payment options.

Saturday, January 06, 2007

My view on life insurance

Prior before working in the financial service industry, I just graduate from college looking for a job. Life insurance was never on my mind. Making money was all I thought about and finding a way to build lots of wealth was on my agenda. When I join this company, I would soon find out how many families in America are being screwed. Not just on life insurance, but also mortgages and credit cards. With debt rising in many families, the need for life insurance is important to protect your family. If you die, someone is going to have to pay your debt, which is most likely to be your family.

I believe that life insurance is a necessary tool to have when it comes to financial planning. If you have kids that are dependent on you, why don't you have life insurance? You see, you need to think about others around you in case something happen to you. You are the parent providing a large source of income for the family. God forbids something happen to you, that income won't be there any more. With life insurance, it can prevent that devastation of lost of income.

If you are single, you probably asking why would I need life insurance? First, you are probably a healthy person and a young adult. You can lock in that low rate if you buy life insurance now. The older you get, the more expensive it becomes. Second, your parents or your brothers or sisters probably don't have much save toward retirement. In case something happens to you, they can use the money. Hopefully they will make a wise decision by investing it toward their future instead of spending it right away. I bought a 30 year term insurance at age 23 because that's what I was able to afford at the time. I was single (and still single as I write this blog) and wasn't making much money. I have $150,000 coverage and pay about $25/month for it.

While there are many kinds of life insurance out there, I believe that term insurance is the best way to go. I'm not a life insurance agent, but I do sell term insurance. I'm more of a financial planner or analyst. Life insurance agents say that term is a temporary insurance and premiums will go up when it expires. While that is true, you should compare the cost over time and the value you gain, which I posted in this blog: (click here). Another objection I hear is that term insurance rarely pays out death claim. I don't know how the life insurance agent would know that term insurance rarely pays out death claim. Do you know when you going to die? In 2006, my company paid out over $825 million in death claims. From 1977 to 2006, the company has paid out over $10 billion in death claims. My company never sold cash value life insurance, only term insurance.

You see, life insurance agents will make up every possible reasons to make you buy cash value life insurance instead of term insurance. Why is that? Simple answer: Cash value = big commissions, term insurance = very little commissions. There's an old saying: "If you sell cash value life insurance, you can't sleep. If you sell term insurance, you can't eat." Did you know that most life insurance agents own term insurance and they sell cash value life insurance instead? I can't blame them for wanting to sell cash value life insurance. The company probably pressure their sales force to sell expensive life insurance. When you sit down with a life insurance agent, you should ask what kind of policy he/she has and ask to see it. If they try to sell you a life insurance with a savings plan in it, ask "wouldn't it better to keep my savings separate from life insurance?"

Life insurance agents tend to come back to you to sell you more life insurance policies if you are the client. I seen where one couple had over 10 different life policies on themselves and some more on their kids. That doesn't make any sense to me. Someone is getting rich and the family is left behind in the dark. I believe in doing the right thing for the client by providing the right amount of coverage for the lowest possible cost. I can only achieve that by selling term insurance and help the client invest their money in tax-deferred accounts.

I also believe that you don't need life insurance forever. As you get older, your financial obligations will decrease. Your kids get older, your mortgage is paid off (hopefully before you retire), and you don't have much credit card debt. You are nearing retirement and so, you better have lots of money saved otherwise you will be working for life. So, you going to need to save every bit of money as much as possible. If you still need life insurance when you retire, then dramatically decrease your coverage to $10,000 to cover funeral expenses.

So things to keep in mind when you are considering life insurance:
1) You need to ask yourself why do you need it and who is going to benefit from it in case something happens to you?
2) Term insurance is the best way to go to protect your family. It's even better if you invest your money too in money market accounts, IRA, 401k, etc. Cash value life policies are unable to do this, that's why that when you want to use the cash value, you have to borrow it.
3) Some of you bought life insurance from a family member or from a close friend. You should ask him or her what kind of life insurance does he/she have? It's even better to ask all life insurance agents what kind of life insurance do they have and if it isn't term, ask to see their policy.
4) If you buying term insurance from a life insurance agent, be careful of what kind of term insurance. Most will sell you a 5 year or 10 year term because its very cheap. For a million dollar policy on a 10 year term, you probably would be paying $20/month for it. Few years later, this agent will come back to you and sell you a whole life policy. They will probably say at that time, "you see? Term insurance is expensive! You should buy whole life because premiums remain fix for life!" Which goes with their reason why they think term insurance rarely pays out. It's because they sell a very short term insurance. Get a 30 year term insurance if you can or at least a 20 year term. The cost of a 20 year term or 30 year term is always going to be lower than any cash value life policy over time.
5) You want to purchase life insurance from companies that has strong financial rating from AM Best. AM Best ratings are listed as follow (from superior to poor): A++, A+, A, A-, B++, B+, B, B-, C++, C+, C, C-, D. You want to avoid companies that falls below the B+.
6) Every cash value policy is a term policy to age 100 with a savings plan in it. Your premiums are being paid for two things: term insurance and cash value. The problem is, in most cash value policies, you don't know how much of your premiums is going into each part.

Friday, January 05, 2007

Variable Whole Life

Simply put, its a Whole Life policy where your cash value that is primarily invested in bonds and mortgages. Remember that Whole Life provides permanent lifelong insurance protection, a guaranteed minimum death benefit, and fixed premiums. Since your cash value is being invested, cash value are not guaranteed. You may lose or gain value on your cash value. Your cash value may increase or decrease in direct response to 1) premiums paid, 2) investment performance of the separate cash value that is selected by you, and 3) specified monthly deductions to fund the death benefit portion and provide other benefits.

While death benefit can increase or decrease with corresponding increases or decreases in the cash value, the death benefit can never fall below the guaranteed minimum, as long as scheduled premiums are paid and the policy remains in force.

The rules and procedures governing the withdrawals of cash value are somewhat different from those of traditional Whole Life. Since cash value is created as soon as the first premium is paid, policy loans are theoretically available immediately. After the first policy year, you can borrow up to a certain percentage of the cash value, which is usually between 75% to 90%. When you borrow the cash value, you will permanently affect both the cash value and any death benefit over the guaranteed minimum, whether or not you pay the loan back.

So things to remember about Variable Whole Life:
1) Cash value is not guaranteed.
2) Agents selling this product needs a life license and a securities license.
3) There is a guaranteed minimum death benefit.
4) Any cash value you borrow will affect the value of your cash value and the death benefit above the guaranteed minimum.
5) Agents must provide a prospectus.

Adjustable Life Insurance

Introduced in 1971, Adjustable Life was the first successful attempt to design a policy with dramatically enhances flexibility. You can periodically adjust the amount of death benefit, the amount of premium or even the type of coverage (Level Term to Straight Life to 20-Pay Whole Life, etc.) as your needs change over your lifetimes. In other words, its a traditional policy that has flexibility.

If you are deciding to get an Adjustable Life insurance (which I don't recommend), you will be presented with three choices. You can only make a decision on two of them, which will determine the third choice. Your choices are: 1) How much protection do you want? 2) How much premium can you afford? 3) The type of plan (term, whole life, etc.)

Let's say you want $150,000 coverage and can only afford to pay annual premiums of $500. These two choices (along with your age and other underwriting factors) might dictate that the contract will initially be a term to age 65 policy. Or, if you want cash value (which I don't recommend), you can decide you want a Whole Life plan and be able to pay annual premium of $800.

When the policy is enforced, you can change your face amount, change your premium payment period, or change the protection period. Remember, you can only control two choices, which will determine the third choice. There may be some restrictions on how often you can make adjustments in your policy and you may have to pay a fee to make the adjustments. If you want to increase your coverage amount, you will need to provide proof of insurability.

The problem I have with Adjustable Life is that it is complicated product to understand. Sure it gives you flexibility, but at what price are you willing to pay to make these adjustments? What you don't understand is that when you make adjustments, you can affect the value of the policy. Also, Adjustable Life are proven to be somewhat cumbersome and costly from an administrative point of view. The relative cost per thousand of coverage under the various plans tend to be somewhat higher than with traditional policies (whole life and term). When Adjustable Life is in cash value mode, it earns a fixed rate of return.

Since the time Adjustable Life came out, most companies have evolved it into a Universal Life or Variable Life policy, which have proven to be ven more effective in meeting a broader range of consumer needs.

Wednesday, January 03, 2007

Coverdell Education Savings Accounts (ESA)

Coverdell Education Savings Accounts (ESAs) are designed to be used by those saving for a child's future educational expenses. Annual non-deductible contributions of up to $2000 per beneficiary can be made until the beneficiary turns 18. Withdrawals to pay higher education expenses of the beneficiary are tax-free as long as the money is used prior to the beneficiary reaching age 30.

The $2000 contribution is phased out for taxpayers with a modified AGI above $95,000 ($190,000 on joint return). No contribution to an ESA is allowed once the modified AGI is $110,000 ($220,000 on joint return). However, a grandparent, or other person under the earnings ceiling, can make the contribution to the child's account. You need to be careful here if other people are contributing to the account since only a maximum of $2000 can be contributed. Earnings in ESAs grow tax deferred.

If there are any proceeds left over when the beneficiary becomes age 30, the balance will be paid to the beneficiary within 30 days. There will be an income tax plus a 10% penalty tax if the proceeds are not used before the beneficiary reaches age 30. If the beneficiary dies before age 30, the balance will be paid to the beneficiary's estate, unless his or her legal representative changes the beneficiary to a surviving spouse or another family member under age 30. A legal representative is either a parent or a guardian.

If child doesn't want to go to college, you can change the beneficiary to another child under age 30.