Introduction to Personal Finance:
Beginning Your Financial Journey
By John Grable and Lance Palmer
1st Edition
Chapter 7
The Foundation of Savings
Prepared by
Robin Henager Greene
Whitworth University
Chapter Outline
Learning Objectives (1 of 2)
LO 1 Describe the relationship between investment risk
and return.
LO 2 Explain why an emergency fund is critical for
financial well-being.
LO 3 Identify the use and benefits of savings accounts,
money market savings accounts, and certificates of
deposit.
Chapter Outline
Learning Objectives (2 of 2)
LO 4 Explain how a Roth IRA provides savings and tax
benefits.
LO 5 Describe the benefits and limitations of U.S.
savings bonds.
LO 6 Discuss the different types of custodial and
beneficiary accounts and their appropriate uses.
LO 7 Recognize financial frauds and the strategies to
protect against them.
Risk and Return (1 of 2)
Risk – the possibility of losing money if…
• prices increase over time - inflation risk
• a company in which you invest closes - business risk
• general interest rates increase - interest rate risk
(reduces the value of investments)
• you cannot sell something you own due to a weak
market - liquidity risk
LO 1
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Risk and Return (2 of 2)
Return – money you make on an investment
Nominal return: Actual percentage return
• For example, 1% return for your bank account
Real rate of return: Inflation-adjusted return
• For example, if prices increase by 3%, you really lose 2%
in purchasing power
LO 1
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Assessing Risk
1. Subjective risk: Perception of the riskiness associated
with a behavior or decision
•
•
•
based on your personally developed probabilities of
potential losses
based on expectations, fears, and worries
varies from one person to another
2. Objective risk: Ranking of risk using actual statistics
•
LO 1
can be measured using probabilities
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Saving and Investing
Savings: Money put aside for short-term goals
Investments: Assets purchased to reach long-term goals
Combine both options over your financial journey to
accumulate wealth
LO 1
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Maintaining Liquidity
Liquidity: how quickly you can convert an asset into cash
• Cash in your pocket
• Assets held in banks and credit unions
• Usually generates lower returns
An emergency fund needs to be very liquid
• Immediately accessible in case of unexpected
expenses
• Basic guideline - between 3 and 6 months of living
expenses
LO 1
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The Investment Pyramid
LO 1
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Investment Levels
Level 1: Setting the Foundation
• Very liquid and often insured assets
• Savings and checking accounts and certificates of deposit
Level 2: Investments
• Assets with potential to make a higher return over time
• Mutual funds, stocks, and bonds
Level 3: High-Risk Investments
• Investments that can generate very high returns/losses
• Gold or other commodities
LO 1
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Concepts in Action (L01)
Which of the following statements is true when you
invest in a federally insured bank account?
a. Given the federal insurance, you are taking no risk.
b. Although there is federal insurance, you are faced
with liquidity risk.
c. Even though there is federal insurance in place, you
still face inflation risk.
d. Given the federal insurance, you are taking significant
business risk.
LO 1
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Overview of Emergency Funds
Pure risk: a risk that results in an economic loss, such as
needing to repair a car or replace a major appliance.
An emergency fund contains easily accessible money that
is specifically set aside to cover pure risk.
LO 2
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Determining the Amount of an
Emergency Fund
1. Estimate your monthly living expenses:
•
•
•
Minimum monthly dollar amount you need each month
All your expenses minus taxes, savings, and nonessentials
Essentials tend to be mortgage or rent, insurance, and car
payments
2. Determine your monetary assets
•
Cash, savings, and checking accounts
3. Calculate your emergency fund ratio
•
LO 2
divide monetary assets by monthly living expenses
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Common Emergency Expenses
LO 2
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Concepts in Action (L02)
Joe has cash in a savings account totaling $7,500, and his
monthly expenses are $2,500.
What is his emergency fund ratio?
a.
b.
c.
d.
LO 2
0.25
3
2
5
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Overview of Savings
Building an emergency fund has an opportunity cost —
you are unable to use the cash for other items, such as a
longer vacation or an investment.
An opportunity cost is the loss of a benefit that you
would have received by choosing another option.
On the other hand, failing to save also has an opportunity
cost—being unprepared to meet a financial emergency.
LO 3
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The Opportunity Costs of an Emergency Fund
LO 3
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Possible Emergencies
LO 3
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Where to Save Your Money (1 of 2)
1. Savings account
• An interest-bearing asset that allows you to earn a small
return on your deposit
• Insured up to $250,000 for individuals
• Allows easy access to funds (ATM or in person withdrawals)
2. Money market account
• An interest-bearing asset that allows you a higher return on
your deposit
• Insured up to $250,000 for individuals
• Allows easy, but slightly more restrictive, access to funds
(ATM, in person, or a check) with limited number of
withdrawals
LO 3
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Where to Save Your Money (2 of 2)
3. Certificate of deposit (CD)
• An interest-bearing asset that allows you an even higher
return on your deposit
• Insured up to $250,000 for individuals
• Generally purchased with one lump-sum dollar amount
• Restricted access to funds with penalties for early withdrawal
4. Dedicated savings account
• Popular variation of a traditional CD
• Allow contributions of money to the CD until the maturity
date
LO 3
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Four Alternatives for Emergency Savings
LO 3
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Concepts in Action (L03) - match the following:
a. Money market
account
1. An interest-bearing account providing
depositors a safe and secure place for
money.
b. Certificate of
deposit
2. The foregone benefit that you would
get from doing the next best thing.
c. Savings account
3. A savings account that restricts
withdrawals until a specific date; in
exchange for a higher interest rate.
d. Opportunity cost 4. An account that pays higher interest
rates than a savings account, with a
restricted number of withdrawals.
LO 1
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Concepts in Action (L03) - match the following:
a. Money market
account
4. An account that pays higher interest
rates than a savings account, with a
restricted number of withdrawals.
b. Certificate of
deposit
3. A savings account that restricts
withdrawals until a specific date; in
exchange for a higher interest rate.
c. Savings account
1. An interest-bearing account providing
depositors a safe and secure place for
money.
d. Opportunity cost
2. The foregone benefit that you would
get from doing the next best thing.
LO 1
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Using IRAs Effectively
LO 4
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Overview of Roth IRAs
Roth IRAs allow individuals to contribute money to a
retirement account on an after-tax basis (does not lower
taxable income), unlike traditional IRAs.
A Roth IRA is an individual retirement account that has
two significant advantages:
1. Investments accumulate earnings tax-deferred
2. Money taken out is tax-free for certain conditions
LO 4
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Roth IRA Withdrawals
Roth IRAs allow three types of withdrawals:
1. Withdrawal of principal any time after the account is
initially funded
2. Qualifying withdrawal of earnings
3. Non-qualifying withdrawal of earnings
The principal is the amount that you deposit into the
account. Earnings are generated from the different types
of investments within the account.
LO 4
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Qualifying Withdrawal
A qualifying withdrawal, also called a qualifying
distribution, of earnings is tax-free if it meets the
following two conditions:
1. You are at least 59½ years old, disabled, or use the
funds to purchase a first home (up to $10,000).
2. The Roth IRA account has been open for at least 5
years.
LO 4
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Traditional IRA Withdrawals
Traditional IRAs do not provide the same flexibility in
terms of withdrawals:
• Some or all future withdrawals from traditional IRAs will be
fully taxable
• Traditional IRAs are subject to early withdrawal penalties
Exceptions to the penalty include:
•
•
•
•
•
•
LO 4
Withdrawals after age 59½
Disability
Upon the owner’s death
First-time home purchase (up to $10,000)
Qualified higher education expenses
To purchase medical insurance if you are unemployed
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Roth IRA Investment Options
With a Roth IRA, you tell the financial institution how to
invest your money, typically with the following
alternatives:
• Bank products (CDs and money market accounts)
• Mutual funds
• Exchange-traded funds (ETFs)
• Stocks
• Bonds
LO 4
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Example Allocation of Assets for Retirement and Emergency Savings in an IRA
LO 4
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Concepts in Action (L04)
Think through your current life situation.
Why would you choose to use a Roth IRA as the type of
account for your emergency fund?
What reasons can you give for choosing some other
option?
LO 4
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U.S. Savings Bonds
A U.S. savings bond is a way for Americans to lend money
to the U.S. government. In exchange, the federal
government agrees to pay you interest.
•
•
•
•
LO 5
Interest is automatically reinvested and is compounded
semiannually.
Interest is added to the value of the bond rather than
being paid out directly to the bondholder.
U.S. savings bonds continue to earn interest for 30 years
from the issue date.
The interest rate paid on U.S. savings bonds varies, but the
rates are generally higher than the savings rates paid by
banks and credit unions.
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Advantages of U.S. Savings Bonds
Savings Bonds are:
•
Easy to buy
•
•
•
Easy to redeem
Tax advantaged
Safe
•
LO 5
Although bank accounts are insured by the FDIC,
savings bonds are backed by the full faith of the U.S.
Treasury
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Disadvantages of U.S. Savings Bonds
Once you purchase a savings bond, you cannot cash in
the bond for at least a year.
If you cash in your savings bond after the first year but
before 5 years of ownership, then you will forfeit the last
3 months of interest earned on the bond (similar to the
early withdrawal penalty for a CD).
LO 5
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Types of Savings Bonds
LO 5
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Options for Purchasing Savings Bonds
1. Set up an account through the Treasury
Direct portal on the U.S. Treasury
Department website
2. Requires a minimum amount of $25
3. The Treasury Department will send you an
electronic record and reference number these bonds are paperless
LO 5
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Options for Purchasing Savings Bonds
1. Use Form 8888 when you file your federal
tax return
2. You will receive the actual paper I bonds in
the mail 4 to 6 weeks after filing your tax
return
LO 5
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Options for Purchasing Savings Bonds
1. Establish a Treasury Direct account and set
up a Payroll Services plan
a. Available from employers that offer
direct-deposit to multiple accounts
LO 5
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Return on U.S. Savings Bond I
Value of a $500 Annual I Bond after 16 Years, Compounded Annually at 1.96%
LO 5
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Concepts in Action (L05)
If you were to purchase a U.S. savings bond, would you
purchase an I bond or an EE bond?
Explain your reasoning and be sure to comment on the
advantages and disadvantages associated with each type
of bond.
LO 5
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How Minors Can Own Property
Minors (< age 18) can own titled assets (such as savings,
investments, and real estate) indirectly through a
custodial account as follows:
• Assets can be given, transferred, or owned by a minor
using the Uniform Gifts to Minors Act (UGMA) or
Uniform Transfers to Minors Act (UTMA) custodial
account
• Minors may also own custodial IRA accounts
• The adult custodian may withdraw money, but the law
states the custodian must use the money only for the
minor’s welfare
LO 6
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Taxation of Custodial and Beneficiary
Accounts
Earnings from investments in UGMA and UTMA accounts
are taxable in the year they are earned.
The minor who owns the account is responsible for
paying the tax on those earnings.
Custodial IRA accounts have tax-deferred growth.
LO 6
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Tax-Planning Benefits of Transferring
Assets to Minors
Nearly all custodial accounts are created through gifts or
transfers from an adult to a child.
For example, gifting stock to a child:
1. By placing the stock into the UGMA or UTMA, the
child must wait until age 18, 19, or 21 (depending
on the state) before he can gain access to the
stock.
2. This may save the adult capital gains tax in the
future.
3. The adult will receive an income tax benefit.
LO 6
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Beneficiary Accounts for Minors
College savings plans are specific types of accounts set
up by states that allow individuals to set money aside for
a designated beneficiary’s higher education expenses.
College savings plans provide:
• Tax-deferred growth on earnings
• Tax-free distributions if the money is used for qualified
educational expenses such as tuition, fees, books,
equipment, housing, meal plans, and other necessary
expenses
LO 6
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College Savings Plans
529 Plans or Qualified Tuition Programs, are popular
college savings plans for parents and grandparents as
these plans allow them to:
• Save for their children’s or grandchildren’s education taxdeferred
• Have tax-free distributions
• Remain in control of the money so that it can only be
used for college expenses
LO 6
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Concepts in Action (L06)
Why would a parent choose to use a 529 plan rather than
a custodial account for college savings?
LO 6
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Financial Fraud and Identity Theft
Financial fraud occurs whenever someone attempts to
deceive you with a promise of goods, services, money, or
other benefits that really do not exist, were never
intended to be provided, or were misrepresented.
The U.S. Justice Department defines identity theft as a
crime in which someone wrongfully obtains and uses
your personal data in some way that involves fraud or
deception for his or her economic gain.
LO 7
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Fraud
Three well-known financial frauds:
1. Ponzi schemes
2. Pyramid schemes
3. Telemarketing fraud
LO 7
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Ponzi Schemes
A Ponzi scheme promises investors a low-risk, high rate of
return, interest, or dividends:
• The fraudsters pay early investors a rate of return
(such as 10%) with money raised from people who
invest later.
• The moment that some of the early investors demand
all their money back or when no new investors can be
found, the scheme falls apart.
LO 7
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Pyramid Schemes
A pyramid scheme is a scam typically based on selling
products or recruiting new members into an organization.
• Recruiters promise high commissions or a sizable share of
money paid by new members.
• Members may not earn high commissions, but may earn
more based on fees paid by new members.
• Can be lucrative to those on the top of the pyramid, but later
members end up losing as it becomes difficult to find new
network members.
• Once the number of new participants declines, the pyramid
crumbles.
LO 7
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A Simple Pyramid Scheme
LO 7
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Telemarketing Fraud
Telemarketing fraud occurs when a product or service is
misrepresented in an unsolicited phone call, e-mail, or
text message.
• A common line is as follows: “I am calling to inform
you that you have won a free gift .”
• The reality is that no one ever gives away something
for free.
• Always assume that there is a catch to the story.
LO 7
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Protecting Yourself from Fraud (1 of 2)
• Never buy something from an unfamiliar person or
business over the phone or Internet
• Never pay a processing fee to receive a prize
• Never invest in something you do not understand
• Never send money overseas to someone you do not
know
LO 7
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Protecting Yourself from Fraud (2 of 2)
• Always ask to receive written material before sending
money or providing account information
• Do not believe that a rich relative you don’t know has
left you money and then pay to get the details
A good rule is to be skeptical whenever it comes to
anything that would separate you from your money!
LO 7
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Identity Theft
Before 1988, identity theft was not considered to be a
federal crime.
This changed when news spread that a convicted felon
had stolen the identity of a man and done the following
in the man’s name:
• Ran up more than $100,000 in credit card debt
• Obtained a mortgage for a new home
• Purchased cars, boats, motorcycles, and guns
LO 7
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The Facts of Identity Theft
Consider the following statistics from the U.S.
Department of Justice:
• Nearly 18 million households have had at least one
person age 12 or older experience identity theft
• More than 35% of all households in the United States
have experienced misuse or theft from a bank,
savings, or utility account
• The total loss associated with identity theft exceeds
$13 billion per year
LO 7
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Identity Theft Protection (1 of 2)
The Federal Bureau of Investigation (FBI) recommends:
• Never throw away ATM receipts, credit statements,
credit cards, or bank statements; always shred or
destroy these documents.
• Never (ever) give your credit card number over the
telephone unless you made the call.
• Never (ever) respond to a phishing scheme—an
unsolicited e-mail asking you to provide personal
information.
LO 7
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Identity Theft Protection (2 of 2)
The Federal Bureau of Investigation (FBI) recommends:
• Always reconcile your bank accounts monthly and
report any problems to your bank or creditor
immediately.
• Keep a list of all your credit cards, debit cards, and
each account’s contact information somewhere
secure, such as a safe deposit box.
• Obtain a copy of your credit report annually and
report anything unusual right away.
LO 7
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Concepts in Action
The population of the United States is approximately
350,000,000 people.
How many cycles will it take for a Ponzi scheme to fail if
the fraud starts with 7 people who are then expected to
recruit another 7 people, with the same growth occurring
at each step of the cycle?
LO 7
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Copyright
Copyright © 2019 John Wiley & Sons, Inc.
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or from the use of the information contained herein.
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