What's your financial IQ?

You follow your stocks, run from pyramid schemes, and save regularly. But do you know enough about investing and personal finance to make the best decisions, avoid preventable losses, and maximize every opportunity? Answer these questions to find out whether you have enough financial facts to protect and grow your stockpile.

1. Municipal bonds can be useful investments because:

• They're backed by the federal government and never lose value.
• They make excellent additions to a 401(k) or Roth IRA.
• Their earnings are almost always free of federal taxes and almost always free of taxes in the region where they were issued.
• Even if a municipality files for bankruptcy, it can't default on its bonds.

2. With interest rates the lowest they've been in years, your bank checking account pays peanuts. You want to earn more, but with the least possible risk. Which of the following would you avoid?

• Short-term, high-quality corporate bonds.
• Long-term corporate bond funds.
• Certificates of deposit.
• Money-market funds.

3. You want to reduce monthly debt payments. All the following tactics will lower your current outlay, but which should be a last resort?

• Taking out a tax-deductible home equity loan to pay off your high-interest credit card debt.
• Refinancing your mortgage to get a lower rate, no matter how many years are left on the loan.
• Shopping for a low-rate personal loan or refinancing one you've already got.
• Transferring your credit card balances to a card with a lower interest rate.

4. Your estate plan is five years old. Which one of these is NOT a good reason to update it?

• Because of tax-law changes, your plan may no longer accomplish what you intended.
• Divorce and other family events may have changed how you want your funds distributed.
• The lifetime amount exempted from the federal gift tax went from $675,000 to $1 million in 2002, allowing you to further reduce your taxable estate.
• Your income has declined and you're now in a lower marginal tax bracket.

5. When deciding which mutual funds to keep and which to unload, you should strongly consider keeping a fund that:

• Has shifted its focus from the one stated in the prospectus.
• Has a beta substantially greater than the average for the funds in its investment category.
• Has a below-average three-year return for its category, which is currently out of favor.
• Has returns that are lower than they were in prior years but are above those for its peer group and its market benchmark.

6. Beginning this year, tax law changes let you sock away more dollars for retirement. Three of the following tax breaks were created. Which one wasn't?

• For 2002, the allowable contribution to a Roth or traditional IRA increased from $3,000 to $5,000.
• The combined annual limit on individual and corporate 401(k) contributions increased from $35,000 to $40,000 per person.
• The compensation limit on which you base your contribution to a defined-contribution plan rose from $170,000 to $200,000.
• If you're 50 or over, you can make additional catch-up contributions of $1,000 for 2002 to your 401(k) plan; and catch-up contributions of $500 to your traditional and Roth IRAs.

7. You may be nervous about investing in equities, but you should have a portion of your portfolio in stocks—rather than keep it all in bonds, CDs, or money markets—particularly for long-term goals. Why?

• Over the past 75 years, the S&P 500 has had an annualized total return of 11 percent.
• Over the past 75 years, the S&P 500 has had an annualized total return of 16 percent.
• Investing aggressively lowers your risk during times of market turmoil.
• You have a greater choice of stocks than bonds.

8. You want to spend less time managing your investments and personal finances. Three of these tactics can help; which one won't?

• Selling funds whose holdings overlap those of other funds you own.
• Investing through a mutual fund supermarket.
• Buying software that lets you bank and pay bills automatically online.
• Taking out a line of credit to make larger monthly payments toward your bills.

9. Which of the following tax-saving moves might land you in hot water?

• Paying some of next year's deductible expenses this year.
• Selling stocks that have sunk to cancel out gains from appreciated stock that you've sold.
• Waiting until January to cash payment checks received in December, so you can claim the income in the current year.
• Submitting some billings to insurers late in the year, so that income normally collected in December will arrive in January.

10. If you're investing for the long run, your portfolio should contain some value stocks or mutual funds that invest in them. Which best describes a value company?

• It has a high P-E ratio and stock price, which is consistent with its above-average growth rates.
• It has sound fundamentals, but temporary problems have caused its stock price to fall more than it should, given the company's intrinsic worth.
• It's had low stock prices, little growth, and high debt for years, and analysts say it has systemic problems.
• Its stock normally trades at above-average prices but sells at a discount to preferred investors.

Answers

1. c. Uncle Sam almost never taxes municipal bond earnings, and state and local governments rarely tax earnings on bonds they issue; that's why you accept municipal bonds' lower yields. Since munis already escape most or all tax, putting them into tax-deferred or tax-free accounts offers no additional benefit. Munis aren't backed by the federal government and could default.

2. b. With long-term corporate bond funds, you can lose principal; the interest rate could be lower than a short-term bond fund could bring; and corporate bonds carry a risk of default. The manager of a fund whose holdings have short maturities can more easily replace low-yield bonds with higher-paying ones when rates rise. Short-term bonds are also less volatile and risky than long-term bonds. CDs and money-market funds carry little or no risk.

3. b. If you've been in your home a long time, stretching out the loan for another 30 years might make only short-term sense. The long-term costs—in interest dollars and in the delayed security of owning your home free and clear—are high. Avoid them, if possible.

4. d. Current income taxes have little bearing on the taxation and distribution of your estate. Tax-law and family changes can mean you need a new estate plan to accomplish your goals. The federal gift tax exemption did indeed increase in 2002 and that may well impact your estate planning.

5. d. If a fund's returns beat those of its benchmark while others in the same investment category have plunged, it's probably worth keeping. The category may be out of favor, but the fund is performing well for its mandate. If the fund has shifted its focus, you're not getting the investment strategy that you originally selected. A beta greater than the category average means the fund is more volatile and is probably incurring more risk for its returns. If it underperforms its peers for several years, you may simply own a dud.

6. a. The maximum Roth or traditional IRA contribution has risen to $3,000 per person, not $5,000. One exception: Those 50 or older can contribute up to $3,500.

7. a. Over the past 75 years, the S&P 500 has had an annualized total return of 11 percent. Investing aggressively never lowers your risk. Having more stocks to select from than bonds has no bearing on why you should invest in equities.

8. d. Taking out a line of credit does nothing to simplify your financial life. But dumping funds that overlap others you own shrinks the number of funds you must follow. And by investing through a fund supermarket such as Charles Schwab & Co., you can consolidate all your fund data into one monthly statement.

9. c. If you receive a check dated in December, the IRS assumes that's when you were paid, no matter when you cash the check. Paying some of next year's deductible expenses this year can be a smart move. Selling loser stocks to offset gains from appreciated stocks can help you cut your tax bill. Timing year-end billings so that you receive income in January rather than December can work in your behalf.

10. b. A value company has sound fundamentals but a low P-E ratio and depressed share price. Analysts believe that the company's problems are temporary, not systemic flaws with long-term implications.

Scoring

7–10 right: You may not be a Rockefeller yet, but you're knowledgeable and up to date about a wide range of personal financial topics. Mostly likely, your own money matters are well under control.

4–6 right: You've got a general comprehension of financial issues. A little more attention to investment and tax topics might quickly boost your expertise.

0–3 right: Your personal bottom line would probably look a lot better if you took the time to learn more about personal finance and investing.

Leslie Kane. What's your financial IQ?.

Medical Economics

2002;7:102.