BASIC INVESTING TERMS

BASIC INVESTING TERMS

This episode will not get into the details of how to invest or offer any tips or advice on actually investing your money. I just wanted to go over some terms that we often hear related to investing that we might not always understand. It’s good to have a basic understanding of the different types of accounts and language used related to investing. There is so much to know about investing if you want to really get into it. This is just the basics, and I’m sure there are more basics that I could cover.  But, I am just going over what I know.

Please also note that when I explain the benefits of some of the types of retirement or college savings accounts, most of them do have exclusions or limits.  There are exceptions to who can use those types of accounts usually based on income.  So, always make sure to consult a financial or tax advisor before you make decisions to put money in any particular type of account.

BASIC RETIREMENT SAVINGS TERMS

IRA

An IRA is an individual retirement account.  The word individual is key.  An IRA cannot be a joint account, there can only be one person’s name on the account.  Of course, you can have a beneficiary on the account, but the account itself can only be in the name of one individual. An IRA is an account that you would open up on your own, not through an employer.  You would do this through a financial institution either in person or online. There are limits as to how much you can contribute to an IRA each year.

If you have a spouse, those limits are applied separately.  So, you can each contribute to your own IRA up to the limits in place. If you open up an IRA it is important to understand the IRA is just a type of account.  It is not an investment. Once you have money in your IRA account, you need to then choose how to invest that money. Money is not automatically invested once placed in an IRA.  If you do not choose how to invest the money, it will just sit there earning very minimal interest.

Traditional IRA

A traditional IRA is a pre-tax retirement account.  So, money that is deposited into a Traditional IRA generally can be deducted from your income in the year you deposit money into the account. By being able to deduct your Traditional IRA deposits for tax purposes, you reduce your taxes in the year you make the contribution. You will not pay tax on the earnings in your Traditional IRA each year. The money is not taxed until you take distributions from the account. If you take money out of the account before the age determined by the IRS, currently 59.5, you will pay taxes and penalties.

With a traditional IRA, you are also required to take required minimum distributions.  This is frequently abbreviated as RMD. Depending on when you were born, currently, the age is 70.5 or 72, where you must take RMDs. The IRS does not want the money sitting in that account forever, don’t forget you don’t pay tax on that money until it is taken from the account. The reason people save for retirement in a Traditional IRA is they expect their tax rate will be lower during retirement when the money is taken out of the account. So, rather than pay tax on that money now at a higher tax rate, they defer the taxes until retirement. This is why it is called a tax-deferred account. Currently, the annual contribution limit on Traditional IRAs is $6,000 if you are under 50, or $7,000 if you are over 50.

Roth IRA

A Roth IRA is an after-tax retirement account. Money that is deposited into a Roth IRA is not deductible for tax purposes. The money that you put into a Roth IRA has already been taxed, so it will not be taxed later when you take it out. The benefit of a Roth IRA is that the earnings on the money you invest not only grow tax-free but are not taxed at the time you take a distribution either. Often people with a long time horizon for investing in retirement will choose a Roth IRA because the money has a long time to grow in value. When the time comes to retire as distributions are made from the account it is all tax-free.

The contribution limit for a Roth IRA is the same as a Traditional IRA.  However, it is important to note that if you are investing in a Traditional and Roth IRA the contribution limit applies to them on a combined basis. So, for example with the $6,000 limit, if you invest $3,000 in a Roth IRA and $3,000 in a Traditional IRA you have met the limit. Some people choose to invest in both types because no one knows what their tax rate during retirement will be for sure.

Tax laws can change at any time.  So, for this reason, some people make the decision to do some of their contributions before tax in a traditional IRA and some after-tax in a Roth IRA. Again, things can change, and there are always exceptions in the tax laws.  So, it’s important to look at your particular situation and consult an expert before making decisions to invest in any of these types of retirement accounts.

401k accounts (403b for non-profits)

A 401k account is an account that is opened up through an employer. Often employers offer some type of match on contributed funds. There is usually a limit on what they will match. For example, an employer might say they will match 100% of your contributions up to 3% of your pay.  Or they might say, they will match 50% of your contributions up to 5% of your pay.  There are many different ways employers can choose to set up matches.

If you are able to contribute at least enough to get those matches, you are getting that extra money for free. Similar to when opening an IRA is important to make sure you choose how to invest the money in your 401k. Depending on how the account is set up, the options are usually not as broad as in an IRA.  However, if you do not choose your investment option, your money will typically be placed in a cash account.  In this case, you will be earning at a rate similar to a regular savings account.  That’s basically nothing. 

Traditional 401k

As far as the tax benefits, it is basically the same as a Traditional IRA. Money is taken from your paycheck before taxes and deposited into the account. So, taxes will be paid later on that money and any earnings at the time you take distributions. Distribution age, minimum distributions, early withdrawal penalties, etc. are all the same as in a Traditional IRA. The difference is that you can contribute up to $20,500 per year.  If you are over 50, you can contribute an additional $6,500 per year.  The additional $6,500 is called a catch-up contribution. These amounts generally change each year. Contributions to a 401k do not count towards the IRA limit.  So, if you are contributing to a 401k account, either traditional or Roth (which I will cover next), you can still contribute to an IRA account.

Roth 401k

Many more employers are now offering this option to employees for their retirement savings. As far as the tax benefits, it is basically the same as a Roth IRA. Money is taken from your paycheck after taxes and deposited into the account. So, money and any earnings at the time you take distributions will not be taxed. Distribution age, early withdrawal penalties, etc. are all the same as in a Roth IRA. The contribution maximums are the same as a Traditional 401k. And again contributions to a 401k, Roth, or Traditional, do not count towards the IRA limit.  So, you can still contribute to an IRA account if you have the funds available.

NON-RETIREMENT INVESTING

There are also many options for investing money in non-retirement accounts. Depending on the type of investment, generally, the earnings on these accounts are taxed on an annual basis. You can take the money out at any time as you need it, without incurring any penalties as far as taxes go. A non-retirement investment account is called a brokerage account. Similar to opening an IRA these accounts can be opened in person at a financial institution or online.

Once you open the account, again you will have many options to invest your money. The account is just a vehicle to hold your investments. I am not certain if some brokerage accounts may limit you to purchase from their investments.  So, you would want to be sure about that. But, for example, if you open a brokerage account with e-trade for example, within that one account you could potentially own several stocks, a couple of different mutual funds, and cash. So, the account itself is not an investment.  You invest the money how you want within the account.

BASIC INVESTING TERMS

Conservative investment

Typically conservative investments consist of bonds or very low-risk stocks.  The main goal of conservative investing is to have some growth, but greatly reduce the risk of losing value of the amount initially invested.

Aggressive investment

Aggressive investments usually consist of all stocks.  These investments often change greatly in value and are at the most risk of losing value when the market declines.

Investment strategy

Unless we are nearing the point where we will need to use our investments, most of us fall somewhere in between being totally conservative or totally aggressive. You can speak to an advisor or do some searching online for a mix of investments that will get you somewhere in the mid-point based on how many ups and downs you are able to feel comfortable with.

Index Fund

An index fund is a fund that holds a wide range of investments in various companies.  They are created to mimic an index such as the S&P 500. When you invest in an index fund, you are purchasing a small piece of many companies, rather than trying to pick stocks on your own.

Fractional Shares

Some brokerage accounts will allow you to purchase fractional shares.  A fractional share is a portion of a share.  For example, say you want to invest in a company whose stock is trading for $300 per share, but you only have $100 to invest. If the account you have allows the purchase of fractional shares, you could invest $100 in the company to purchase 1/3 of a share. Not all accounts allow this, but there are many out there that do.  So, if that is something important to you be sure to see if that option is available.

Unrealized Gains and Losses

An unrealized gain is a gain that you have not realized yet, meaning it could still change. For example, say you invest $100 in a mutual fund.  If you look at your investment statement today and the value of that fund has increased to $120, you have a $20 unrealized gain. Tomorrow you may look at the fund and the value may have declined to $90, meaning you would then have a $10 unrealized loss. It really just represents how the current value of your investment compares to your initial investment. You really have no true gain or loss until you sell your investment.

Realized Gains and Losses

A realized gain or loss occurs when you actually sell all or part of your investment. Using the same example, if you invested $100 in a mutual fund and then sold it when it was at a value of $120, you would have a realized gain of $20. So, until you sell your investment, you haven’t really gained or lost anything.  The value can continue to change over time.

Dividends

A dividend is a distribution of earnings to its shareholders. Not all stocks issue dividends.  Those that do are usually on a monthly or quarterly basis. A dividend will be issued as a certain amount per share.  So, the amount of money you will receive depends on how many shares or fractions of a share you own in the company.

Auto-Reinvest

You will need to decide if you want to auto-reinvest the earnings on your investments. Say for example you own a mutual fund or stock that receives dividend income.  You can either have that money come to you in cash and then decided how you want to invest it. Or you can have that money auto-reinvested meaning it will purchase more shares of the stock or mutual fund that it was earned from.