Putting money away in a retirement plan (IRA, Roth IRA, annuity, etc.) or investing in mutual funds or stocks are all ways you can build your nest egg. The questions and answers below are intended to provide you with basic information about investments and retirement plans.
Are there simple guidelines to follow to reach a comfortable retirement?
Yes. It is always a good idea to contribute as much as possible to retirement plans, to take advantage of tax deferral and employer matches.
If you start your savings plan in your early 20s and save 10% of your income, you’ll have a sufficient nest egg by the time you retire. If you are in your 40s when you start to save for retirement, you might have to put away upwards of 20%. This is all dependent on the time of your life that you begin to save, the size of your current nest egg, and the amount of money that you will need to retire comfortably.
It is always a good idea to contribute as much as possible to retirement plans, to take advantage of tax deferral and employer matches.
For the first few years after retirement, most people need around 80% of their pre-retirement income until they learn how to live on less. This can vary greatly depending on their expenses.
It is also useful to have an emergency fund with at least six months of expenses in it. You can always adjust it.
What risks are you exposed to when investing?
Educating yourself is the best thing you can do to limit your risk exposure.
When the rate of return is significant, the risk usually is as well. Depending on the situation, you may put yourself at risk to lose all of your initial investment.
What can you do to avoid taking unnecessary risks?
There are several precautions you can take.
Here are some suggestions:
When you receive your monthly statements, double-check them to make sure everything is correct and that there are no irregular charges.
What factors should be considered before making a stock investment?
You have to decide on your comfort level, risk limit, etc.
Here are some questions to ask yourself:
You may also want to speak with a financial professional who can offer you their expert advice.
What factors should be considered before investing in a mutual fund?
All funds carry some degree of risk. Before investing any of your money, read a fund’s prospectus and shareholder reports. This will tell you about the fund’s strategy and what the possible risks involved might be.
What should you specifically look for?
Speaking to a financial expert or your CPA can also prove useful.
What investment pitfalls should you look out for?
Do you need to allocate your IRA investments?
Yes. Treat IRAs like any other investment, consider how much risk you are willing to take on and act accordingly.
If you are risk-averse, fixed short-term investments will be a better fit for your risk profile.
Be careful about putting your investments in municipal bonds. You may sacrifice return on your investment that could convert tax-free income into taxable income.
What should be taken into account when you start investing?
It’s important to decide on a realistic financial goal for yourself and your family.
Talk with family members to ensure that everyone has the same goals in mind. Determine what is important to you, whether it is early retirement, financial comfort, education, travel, taking care of elders, or your children.
Risk vs. Return. Determine what sort of Return on Investment (ROI) you are seeking.
Asset Allocation. This is the selection of assets (i.e., stocks, bonds, and mutual funds.) Asset allocation allows you to minimize risk.
Diversification. Similar to asset allocation, diversification is when you spread your investments within the same category.
Monitoring Progress. Examine your trading records to ensure that all of the trades went through at the prices that you instructed and with the correct commissions. Create a paper trail of all the transactions that occur in your portfolio.
Keep tabs on how your assets are performing. If you notice they are under-performing, it may be time to make changes to your investments. Check that your investments are in line with your current investment strategy. If you don’t want to track this yourself, contact a financial services professional to help.
What are the biggest mistakes investors make?
At some point we’ve all made an investment that we haven’t thoroughly thought through. And then panic sets in.
How can you avoid future investment snafus? Here are some things to avoid:
What is an annuity?
An annuity is an insurance contract. The insurance company invests in stocks and bonds on your behalf with the tax deferred money.
When you reach age 65, you will begin to receive payments. These payments will fluctuate with the prices of the underlying securities. An annuity guarantees you will receive payments until your death.
Annuity contracts often carry various charges. These charges vary from company to company and are worth reading before purchasing the annuity. Annuities are not securities and so are not regulated by the SEC.
What should you beware of when investing in an annuity?
You will not be able to withdraw any of the money in an annuity during its tax-deferred growth period without incurring significant fees. You will be charged a 10% penalty under the tax code and the insurance will usually charge "surrender charges" on top of that if you do withdraw funds early.
What types of annuities are available?
There are two main types of annuities—immediate and deferred.
As their names indicate, immediate annuities allow you to collect soon after your purchase, while you must wait for payment (often years) from deferred annuities, which are not taxable for that duration.
Here is a list of the various types of annuities and what they offer:
How and when can you collect from an annuity?
You have a few choices when choosing to collect your annuity.
Some people opt for a lump sum. However, this negates one of the major benefits of the annuity: payments until death.
The amount of the monthly payments that you receive depends on:
There are various settlement options for annuities.
How are annuity payments taxed?
The tax rates differ for tax-qualified and non-qualified plans.
An annuity that is tax-qualified is one that funds a qualified retirement plan. When this qualified annuity is used it follows the same tax laws as these retirement vehicles: tax deferral during the gestation period and the promise that earnings will not be taxed until withdrawn.
A non-qualified annuity is bought with after-tax dollars, but the benefit of tax-deferred savings still applies.
What is the Rule of 72?
The Rule of 72 helps calculate how long it will take your investments to double at different interest rates.
Take the rate of annual return on your investment and divide 72 by that number. The result is the number of years it will take for you to double your investment.
What taxes are annuities subject to after the annuitants’ deaths?
Annuity payments to beneficiaries are subject to the same taxes that would have been collected from you.
Please refer to IRS Publication 939 for more information on how to calculate the taxable percentage of non-qualified annuity payments.
You may also want to look into death benefits riders that increase the size of your beneficiaries payments.
What should be taken into consideration when shopping for annuities?
Your risk. How much risk are you willing to take? Make sure that the broker understands your risk tolerance.
What hidden costs may be associated with an annuity?
What about other fees?
There are numerous fees associated with annuities.
These fees should be stated plainly in the prospectus.
What is a bond?
A bond is simply a certificate that the borrower promises to repay within a certain period.
For the privilege of using the money, the company, municipality or government entity agrees to pay a certain amount of interest per year, usually an exact percentage of the amount loaned.
As a bondholder, you do not own any part of the entity you loaned the money to nor do you receive the benefits of dividends or the privilege to vote on company matters. The success of the investment isn't related to that company's record in the market, either. You are entitled to receive the agreed-upon amount, as well as the principal of the bond.
Corporate bonds are issued in denominations of $1000 (face value). Bond prices can differ from their face values because the prices of the bonds are correlated to the current market rates. When these rates change, the value of the bond also changes. If you sell the bond before it matures, it may be worth less than you paid for it. A “callable bond” is one that the issuer may choose to buy back at full face value before the maturity date.
There are three major features of bonds:
Short-term bonds mature in two years or less. Long-term bonds mature in 10 or more. Intermediate bonds mature between two and 10 years.
What is bond quality?
Bond quality is the rating of the creditworthiness of an issuing organization.
The higher the rating is, the lower the risk of the investment. The rating system uses letters A through D. The only bond considered to be risk-free is the U.S. Treasury Bond.
How does the bond rating system work?
Bond quality is the rating of the creditworthiness of an issuing organization.
There are organizations that specialize in judging bond quality. The higher the rating, the lower the risk of the investment. The rating system uses letters A through D.
An example of the rating system is shown below:
|Highest Quality||Moody's||Standard & Poor's|
How do interest rates affect bond prices?
Bond prices and interest rates are opposites. As one rises, the other one drops.
The interest rate determines whether a bond is sold at a discount (par) or a premium price. If a bond's interest rate equals the current market interest rate, the bond will be sold at par. This means that the issue price of the bond (e.g., $1000) is the same as the face value (the amount you receive at maturity.
If a bond interest rate is not the same as the current market rate of interest, the price will increase, but the face value will remain the same. Why would you do this? It could be you want to lock in a higher interest rate. If the bond rate is lower than the market rate, the bond will be discounted.
How does maturity affect bond prices?
Bond prices are heavily influenced by maturity.
The longer bonds are left to mature, the greater the change in price for a change in interest rates. Due to this, bond fund managers attempt to change their fund's average maturity to anticipate changes in interest rates.
What is a call provision?
In a bond call provision, the bond issuer can redeem the bonds after a specified amount of time.
This will not guarantee a continuation of a high yield after the call date as it limits the appreciation of the bonds, and it makes the investment riskier. Bond call provisions can be complex.
Should bond funds be purchased directly or through a mutual fund?
It depends on the amount of flexibility you want.
A bond mutual fund contains multiple bonds. For that reason, it is impossible to lock in the payment rate or the principal, which you would be able to do if you were directly buying a bond.
A bond mutual fund is an investment company that manages a portfolio of individual bonds. You as an investor purchase ownership in the company. Each share you purchase represents ownership in all of the company's holdings. Managers use these investments to buy and sell bonds that align with the objective of the fund.
Liquidity plays a major role in bond buying. If you purchase a bond individually and wish to sell it, you must find a buyer for your bond. If you invest in a bond fund, the fund has to purchase your shares back any time you choose.
What are the different issuing organizations?
Bonds can be issued by municipalities, the U.S. government and the Federal Reserve.
How are mutual funds taxed?
Distributions from mutual funds should be reported as income, whether you reinvest them or not.
Taxable distributions come in two forms: ordinary dividends and capital gains. The distributions of ordinary dividends represent the net earnings of the fund and are periodically paid to shareholders. Mutual fund distributions are considered to be dividends, and must be accounted for accordingly.
Can tax be avoided by reinvesting mutual fund dividends?
Funds will give you the opportunity to reinvest in the fund automatically.
This does not prevent you from paying tax on your assets. However, your reinvestment will prevent you from paying more "buy" fees to get into the fund, so it is advantageous.
What taxes apply to return-of-capital distributions?
Sometimes mutual funds distribute monies to shareholders that haven't been attributed to the funds’ earnings. This is a non-taxable distribution.
How does stock trading work?
Stocks are usually traded in quantities of 100 shares, called round lots. Any quantity of stock under 100 shares will be considered an odd lot.
What is the difference between Preferred and Common Stock?
Most stocks are common stocks.
Common stocks are based on company performance while preferred stocks will usually have a stated dividend.
Preferred stocks offer advantages regarding dividends. Holders of these stocks do not have the same voting rights that the holders of common shares do.
What is involved in investing in foreign stocks?
It is fairly easy to invest in foreign corporations, as these corporations need to register their securities with the Securities and Exchange Commission (SEC). The companies are subject to the same rules as U.S. firms.
Mark S. Freedman, CPA Inc.
8949 Reseda Blvd., Suite 123
Northridge CA 91324
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