How Do Options Work?

A call option gives an investor the right to buy 100 shares of a particular security at a predetermined price (the strike price) before a set deadline (the expiration date). A put option gives an investor the right to sell 100 shares of a particular security at a predetermined strike price before a set deadline. An investor can purchase both put and call options, or sell (write) both put and call options. An investor who writes a put option is giving another investor the option (but not the obligation) to force the put writer to purchase a security at the strike price before the expiration date. An investor who writes a call option is giving another investor the option (but not the obligation) to purchase an underlying security at the strike price before the expiration date.

An investor who writes, or sells, a put or call option collects immediate income. That investor is hoping the option does not get exercised in which case the premium collected is all profit. If the option is exercised, the option writer is obligated to buy or sell the underlying security at the strike price. This could lead to potentially large loss for the option writer.

An investor who purchases a put is seeking protection from a decrease in value of the underlying security. An investor who purchases a call is attempting to capitalize on an increase in value of the underlying security. Purchasing a call usually requires only a small investment. If the call is exercised, it may results in a large return for the investor. If the call expires without being exercised, the call purchaser suffers a 100 percent loss.

Clearly, options are complex and risky investment tools. One should not invest in these products without a thorough understanding of the risk involved. Additionally, option contracts are usually purchased to supplement a more complete investment strategy. Be sure to speak to an independent fee only financial planner before even considering these investment products.

What Are REITs?

As an investment class, real estate offers several major advantages. Real estate is a great inflation hedge, meaning when inflation is high, the value of real estate investments usually increases dramatically. Second, real estate offers several unique tax advantages, such as the ability to deduct interest expense and depreciation. Third, few investors pay 100 percent cash when they buy real estate. Rather, they use leverage (borrow money to fund the investment). This provides the investor the opportunity to benefit from investment gains utilizing borrowed funds. Lastly, real estate investments are often relatively uncorrelated with stock market gains. Thus, owning real estate is a great way to further diversify a portfolio.

However, owning real estate directly has its disadvantages. First, real estate is illiquid, meaning it is difficult to convert into cash quickly. Second, even if the majority of dollars required are loaned to the investor, investing in real estate requires a high minimum investment. Third, investing in real estate involves a large amount of personal liability. Lastly, real estate investments have significant transaction costs, such as commissions, appraisals, and closing fees.

Real estate investment trusts (REITs) provide investors a way to invest in real estate without being exposed to the above disadvantages. REITs are publicly-traded investment corporations that are traded on major stock exchanges such as the NYSE. Being traded on public exchanges provides liquidity to the investment. Further, REIT shares can be purchases with relatively small amounts of money. Also, the investment corporation bears most of the liability, making individual investors’ assets secure from creditors. Lastly, REITs generally purchase many individual properties, providing diversification within a real estate portfolio.

REITs are a great addition to many portfolios. However, keep in mind that for most investors a home is their largest asset. Consequently, investors should be careful not to overweight the real estate portion of their portfolios. In most cases, investors shouldn't invest more than 15 percent of their portfolio in real estate (excluding the home).

What Are Equity-Indexed Annuities?

An equity-indexed annuity is an annuity that’s value is linked to a stock or market index; the S&P 500 index is most common.

Equity-indexed annuities have a guaranteed minimum rate of return (also referred to as a floor). This guarantee is usually between 0 and 3 percent annually. In exchange for this guarantee, equity-indexed annuities also have a cap, which is the maximum rate of return the investment can make in a given year. Currently, most indexed annuities have a cap of around 7 percent. Consequently, if the index the annuity is linked to returns 10 percent in a given year, the investor would only be credited with a 7 percent rate of return.

Every equity-indexed annuity has a participation rate, which determines how much of the index’s increase will be used to compute the annuity’s rate of return. Currently, most indexed annuities have a participation rate of between 70 and 100 percent. If the index rate of return during the year was 7 percent, an index-linked annuity with a participation rate of 80 percent would increase in value by 5.6 percent (calculated 80% of 7%, or .8 x .07).

Equity-indexed annuities offer investors a way to participate in market gains while minimizing risk. However, keep in mind the S&P 500 has returned an average of 10 percent annually over the past 100 years, and the majority of these returns have come during years when the market performed much better than a 10 percent rate of return. Thus, an index-linked investment with a cap of 7 percent and a participation rate of 80 percent may dramatically reduce returns over an extended period of time. Additionally, surrender charges are frequently attached to these investments, limiting the investor’s ability to sell without penalties.

Equity-indexed annuities are complex investments. Unfortunately, salespeople are offered high commissions to sell these products. To increase consumer awareness, the SEC developed documentation intended to educate investors about the pitfalls associated with these investments. That document can be viewed at http://www.sec.gov/investor/pubs/equityidxannuity.htm. Consult with an independent fee only financial planner who is never paid commissions to determine if these investments are really appropriate for your situation.

Defining Long-Term Investing

I wanted to share some work conducted by Bert Whitehead, M.B.A and JD. Bert is an advisor at Cambridge Connection and a NAPFA member:

"This year's market bottom (so far) in March wiped out all the market gains in the Dow since 1996. That's 13 years, and that's a hard fact to swallow for a person who's invested in a broad-market index.

So if 13 years isn't long enough, what is?

When I started as a financial advisor in 1972, we were in the recession that had started in 1967. The Dow dropped from 1,000 to 607 from 1967 to 1974. That recession wiped out all gains since 1962 (12 years) and the Dow didn't get beyond 1,000 again until 1982. In fact, there was a widespread belief that the market could never go over 1,000. The financial pundits at that time subscribed to the theory that whenever stocks went beyond 1,000, companies would issue more stock. The additional supply would force the stock prices down, so the supply and demand curves intersected at 1,000.

Instead, the Dow boomed. From 1982 to 2007, the Dow went from 1,000 to 14,000. During that 24-year period, the market rose 9.8 percent per year peak-to-peak. Even measuring trough-to-trough bottoms of the Dow, the market increased an average of 10 percent per year, from 607 to 6,600, from 1984 to this year. The recovery from the Great Depression evinced a similar timeline and valuation pattern. Total average annual equity returns have been easily over 12 percent during the last quarter-century, when you add 4-6 percent dividend payouts.

Deciding not to invest in the market now, especially for younger people, could be the worst financial decision they could make. And remember: You are younger now than you will ever be for the rest of your life."

I'd like to thank Bert for the perspective. Yes, the market has moved sideways for 13 years, but we have been here before. Time and again, history has shown that every 25 year investment period has produced attractive returns.

What Do I Need to Know About Variable Annuities?

Variable annuities enable investors to defer taxes on investment gains until money is withdrawn. Additionally, variable annuities have a death benefit guaranteeing the beneficiary a specified amount – usually the amount invested – upon the investor’s death. For a fee, most annuities offer “living benefits” guaranteeing a rate of return (usually 2 to 5 percent) over time. Withdrawals can be taken as desired, or converted into a fixed periodic payment (annuitized). Withdrawals before age 59½ suffer a 10 percent penalty.

Annuity gains are ordinary income, currently taxed between 10 and 35 percent. While most investments receive a “step-up in basis” that eliminates or drastically reduces the taxes heirs must pay when selling inherited assets, annuities don’t receive a step-up in basis so heirs must pay taxes on the difference between the investment’s cost and current value.

Annuity salespeople are commonly paid an up-front commission ranging from 5 to 10 percent. Although the purchaser doesn’t pay the salesperson directly, the insurer charges the investor high recurring fees to recover this expense. Additionally, separate recurring fees are charged by both the insurer and the underlying funds. After adding the cost of living benefit riders to the contract, fees often exceed 3 percent per year. Comparatively, according to Morningstar the average domestic mutual fund charges 1.35 percent.

Another consequence of high commissions paid to salespeople is the attachment of a surrender charge to annuity policies. Surrender charges discourage investors from withdrawing funds before the insurer recovers the commission paid to the salesperson. This charge usually starts at 7 to 15 percent and declines over 5 to 15 years.

Annuities are appropriate for specific circumstances, such as leaving assets to qualified charities or providing extremely risk-adverse investors with guaranteed income. If you believe an annuity would serve your purpose, it’s time to learn a well-kept secret: you can purchase an annuity without funding a salesperson’s vacation. No-load (no-commission) annuities commonly charge less than half the recurring fees of loaded annuities and have no surrender charge. No salesperson is going to discuss this option. A fee-only financial advisor who isn’t influenced by commission-based compensation can provide an objective opinion on whether an annuity is a wise investment and direct you to a no-load product.

Why it is Important to Understand Your Tolerance for Investment Risk?

Risk tolerance is defined as an investor’s ability to handle declines in the value of his or her investment portfolio. Risk tolerance is a term that is commonly forgotten during periods of extended bull markets, such as the 1990’s, and prevalent during significant market downturns, such as the bursting of the tech bubble and the credit crunch of 2008. Unfortunately, many investors don’t bother identifying their tolerance for risk until it’s too late.

It often takes a major market pullback for many investors to realize their ability to accept risk in their portfolio is not as dominant as they thought. After steep declines in market values, these investors concede they are not comfortable owning such an aggressive portfolio, and they sell investments at a loss in order to make their portfolio more conservative. Of course, selling when investment values are low is not a formula for making money. Consequently, these investors would be better off identifying their appropriate risk tolerance before a market recession, and rebalancing their portfolios while investment values are still high. Then when the inevitable market declines occur, the decrease in an investor’s portfolio will be more in-line with that individual’s ability to accept market losses, making the person less likely to sell at market lows.

The first step in developing a portfolio that matches an individual’s risk tolerance is to identify an appropriate investment allocation between stocks, bonds, and cash. Portfolios consisting of a high percentage of stocks are more aggressive, while portfolios consisting mostly of bonds and cash are more conservative. As investors age, they should constantly reduce the proportion of stocks and increase the proportion of bonds and cash in their portfolio, making their investments less risky.

An independent fee only financial planner can help you pinpoint your risk tolerance and verify it is appropriate for your circumstances. For help with this issue, please feel free to contact me.

What is the Value of Diversification?

Investing involves two basic elements: return and risk. Investors often focus on return because it’s pleasant, but spend relatively little time considering risk-- the potential downside. Risk is most often measured by standard deviation, which is a measure of the variability of returns. An investment with a large amount of variability of returns (a high standard deviation) has the potential to reap large gains or result in large loses.

Total risk consists of two components: systematic risk and unsystematic risk. Systematic risk, also called non-diversifiable risk, is composed of risks that reflect broad economic activity, are market related, and affect all similar types of investments. These risks can’t be eliminated by adding additional securities to a portfolio.

Unsystematic risk, also called diversifiable risk, is composed of risks specific to an individual investment. Factors such as a company’s management, financial structure, earning power, industry, and marketing strengths are some of the specific aspects that can impact the risk of an investment.

Systematic risk is inherent in all investing. Unsystematic risk can be virtually eliminated through diversification. Over time, a portfolio of two unrelated assets can be expected to be less risky than holding each asset individually because the unexpected above-average performance of one asset offsets the disappointing below-average performance of the other asset. Consequently, the variability unique to each individual asset has a greatly reduced impact on the variability of the portfolio as a whole. Thus, having a diversified portfolio of many individual unrelated assets greatly reduces risk while maintaining a consistently high rate of return.

The performance of unique asset classes tends to be relatively uncorrelated. For instance, stocks and bonds do not usually perform in tandem. The same relationship exists between large and small cap stocks, and U.S. and international stocks. To achieve maximum diversification, an investor should own a portfolio consisting of large, mid, small, and international stocks, and own both growth and value style investments. Corporate, government, and international bonds should also be included. Lastly, real estate and commodities can be used to round out the portfolio.

Diversification is a key element of sound financial planning. A portfolio that is well diversified will sustain its value during market declines much better than one that is not. Speak to a financial advisor to ensure your investments are well diversified, which will reduce risk and maximize return in your portfolio.

What do the Various Stock Indices Measure?

The Dow Jones Industrial Average (known as the DOW) is an indicator of stock market prices based on the share values of 30 of the largest and most widely held blue-chip stocks traded on the New York Stock Exchange (NYSE). Each of the 30 Dow components influence the value of the index equally. Develop by Charles Dow, the DJIA is the oldest and most widely used market indicator. Changes are occasionally made to the 30 stocks tracked to keep the index representative of the broad market.

The NASDAQ is the largest electronic trading market in the United States. The NASDAQ Composite Index tracks the value of the approximately 5,000 stocks traded on the NASDAQ market. This index consists of mainly technology stocks, so it is not an accurate indicator of the US equities market as a whole.

The Standard & Poor’s 500 stock index (S&P 500) is a measure of a basket of 500 widely-held stocks listed on the New York Stock Exchange. This index is generally considered to be most representative of the U.S. stock market as a whole. As a value-weighted index, the S&P 500 is more heavily influences by larger companies than smaller firms.

The MSCI EAFE index represents market movements in developed countries outside North America. Most countries represented are located in Europe, Australia, and the Far East. The EAFE index is widely accepted as the best indicator of international stock markets.

Most market indices only account for the current selling price of the measured stocks, and do not consider dividend payments. The failure to include dividend payments means that the annual percentage change of the indices underestimates the true return.

Are 529 Plans the Best Way to Save for College?

529 plans are great college savings tools because, although contributions are not deductible on a federal tax return, earnings withdrawn to pay for qualified higher education expenses such as tuition, books, and room and board are tax-free. The definition of "qualified higher education expenses" was expanded to include computers for 2009 and 2010.

Although contributions to a Utah 529 plan are not deductible on a federal income tax return, the State of Utah will allow the contributor to claim a 5 percent tax credit on up to $3,480 per beneficiary if the contributor is married filing jointly. A tax credit is a dollar-per-dollar reduction of a tax liability, and is thus more valuable than a tax deduction. Consequently, the state will pay as much as $174 of State income tax liability for a 529 contributor who is married filing jointly.

529 plans can be setup for any beneficiary, including your child, grandchild, spouse, neighbor, friend, or yourself. Additionally, the person who contributed the funds can change the beneficiary of the account at any time. Thus, if your beneficiary decides not to attend college, another beneficiary can be named so the tax-free benefit of the account is maintained. Further, the funds can be used at almost every school across the country.

The last advantage of 529 plans is derived from the plan's contribution limits. In 2009, an individual can contribute up to $13,000 per beneficiary. An individual can make a contribution to an unlimited number of beneficiaries, and an unlimited number of individuals can contribute to the same beneficiary. Even more advantageous, an individual can contribute five years-worth of funds in any given year, as long as the combined five year contribution limit is not breached. For instance, an individual could contribute $65,000 to a plan in year one, but would then be prevented from contributing to the plan during years two through five.

A drawback of the 529 savings plan is that if the funds are withdrawn for a purpose other than higher education, all growth will be taxable as ordinary income AND will be hit with an additional 10% penalty. However, if the beneficiary is awarded a scholarship, an amount equal to the tuition covered can be withdrawn from the 529 plan free of the 10% penalty, although taxes would still apply.

Speak to an independent fee only financial advisor for more information about which 529 plan is appropriate for your needs.

Why Roth Conversions Aren't for Everyone

As mentioned in previous postings (Minimize Your Tax Bill and Recharacterizing a Roth Conversion), converting a traditional IRA to a Roth IRA is likely not beneficial for investors who believe they will be in a lower tax bracket during retirement than during their working years. After all, why pay taxes now at a higher tax rate to avoid having to pay taxes later at a more favorable rate?

Another group that may not benefit from a Roth conversion are individuals who will likely have a large amount of itemized deductions on their federal tax returns during retirement. Itemized deductions such as mortgage interest, health care costs (only amounts over 7.5% of adjusted gross income can be deducted), state taxes, and donations can be used to offset income. The IRS does not consider withdrawals from a Roth IRA to be income, so itemized deductions cannot be used to offset Roth distributions. Conversely, itemized deductions can be used to offset traditional IRA distributions.

For example, an individual who converts to a Roth IRA and then has a large amount of medical expenses later in life would ultimately pay taxes up front and fail to take advantage of itemized deductions which would have reduced income taxes on traditional IRA withdrawals. In this case, the individual would have been better off deferring income taxes until he or she had itemized deductions to offset income from traditional IRA withdrawals.

Not sure of the value of your future itemized deductions? A great strategy would be to convert a portion your traditional IRA to a Roth IRA to achieve "tax diversification." A tax diversified individual would have the option of withdrawing money from a traditional IRA account in years when there were itemized deductions to offset the income, or taking tax-free withdrawals from the Roth account in years when itemized deductions were not available. Speak to an independent fee only financial planner if you need help identifying the best strategy for your circumstances.

Thanks to Walt Bleak for collaborating with me on this subject!

How is a SEP Different from an IRA or 401(k)?

Simplified employee pensions (SEPs), while not technically qualified employer-sponsored plans, provide the opportunity for employers to make contributions to employee IRAs. Employees own and manage their own SEPs, so the employer’s administrative cost is minimal. Additionally, employers offering SEPs are not required to make set or recurring contributions to employee plans, so contributions can be made at the employer’s discretion. However, all employer SEP-IRA contributions must be made to each eligible employee and the same percentage of compensation must be contributed for each individual.

SEPs offer several unique advantages. An employer offering a SEP can contribute and deduct as much as 25 percent of its covered payroll. Further, the contribution limit for individual employees is relatively high – 25 percent of compensation up to a maximum of $49,000. SEP benefits make the plan attractive to small businesses and self-employed individuals.

Again, SEPs are only investment vehicles, and participants must choose underlying investments to purchase for their accounts. SEP contributions are deductible on the employee’s income tax return, and investments inside a SEP will grow tax deferred. Funds distributed from a SEP are considered ordinary income. Generally, distributions from a SEP before the employee turns 59.5 will suffer a 10 percent penalty.

What is the Difference Between a Traditional IRA and a Roth IRA?

The biggest difference between a traditional IRA and a Roth IRA is when the assets are taxed. While the traditional IRA provides an upfront tax deduction and tax deferral on an investment’s growth, a Roth IRA does not provide an initial tax deduction but the assets grow tax-FREE.

Which investment vehicle is superior for a particular investor is often a function of whether an individual expects to be in a higher tax bracket now or during retirement. If an investor expects to be in a lower tax bracket during retirement, it would likely be most favorable to use a traditional IRA to defer taxes until the individual can take advantage of a lower tax rate. However, if the investor anticipates being in the same or a higher tax bracket during retirement, it may be a good strategy to pay taxes on the assets now and enjoy tax free growth going forward.

Roth IRAs offer additional benefits. First, because the assets have already been taxed, Roth IRAs pass to an investor’s beneficiaries tax-free. Moreover, because the federal government lacks the ability to tax Roth accounts, it does not require investors to take required minimum distributions (RMDs) from these accounts. Consequently, Roth assets can take full advantage of their tax-free growth. Finally, investors can contribute to a Roth IRA regardless of whether or not they are an active participant in a qualified employer-sponsored retirement plan. However, married couples filing jointly must have an AGI of less than $166k in order to make contributions to a Roth IRA.

Roth IRAs have the ability to accept “converted IRA” funds. A traditional IRA, SEP, or Simple IRA can be converted to a Roth IRA if an investor’s modified adjusted gross income is less than $100,000. Converted funds are taxed as ordinary income, but enjoy tax-free growth going forward. In 2010, all investors, regardless of their MAGI, will have the ability to convert other retirement accounts to Roth IRA accounts. All investors should speak to a financial planner to decide whether a Roth conversion is appropriate for their situation.

What is an IRA?

Individual retirement arrangements (IRAs) are investment vehicles, established without the backing of an employer, that provide tax deferral on investments. Contributions to IRAs can be deductable or non-deductable on a current tax return (depending on whether the tax payer is an active participant in an employer-sponsored retirement plan and their modified adjusted gross income). Both deductable and non-deductable IRA contributions enjoy the benefit of tax deferred growth until the funds are withdrawn from the retirement account. Similar to distributions from 401(k)s, withdrawals from IRAs are taxed as ordinary income.

IRAs have several advantages over 401(k)s. Both investment vehicles are similar in that they are simply tax deferred accounts, and individual investments must be purchased within these accounts. However, whereas most 401(k)s have a limited number of investment options available, a nearly unlimited number of investments are available within an IRA. Consequently, constructing efficient, diversified portfolios is often more easily accomplished within an IRA. (Note that many financial planners make a living by selling annuities within an IRA. This is not in the client’s best interest because an annuity only provides a benefit that the IRA already provides: tax deferral. If a financial advisor recommends that you purchase an annuity within your IRA, find a new financial advisor immediately.)

Additionally, investors with a household income of less than $50,000 may receive a tax credit for contributing to their IRA. This tax credit can be as much as 50 percent of the IRA contribution, up to a maximum of $2,000. Also, when you withdraw money from an IRA, you do not have to withhold 20% of the amount for taxes, which is required when you withdraw money from a 401(k) plan.

Yet, IRAs have several disadvantages when compared to 401(k)s. First, investors can’t take advantage of a company match, which is frequently offered in employer-sponsored retirement plans. In addition, IRAs have relative low contribution limits compared to 401(k)s. In 2009, investors can only contribute $5,000 to their individual retirement accounts, and those above the age of 50 can make an additional $1,000 “catch-up” contribution. Lastly, IRAs are not always protected from creditors. Credit protection for an IRA is determined by individual state statutes.

Investors should only contribute long-term investment funds to their IRA. With only a handful of exceptions, funds withdrawn from an IRA before the age of 59.5 will be subject to a 10 percent penalty. Like 401(k) accounts, required minimum distributions are required from IRAs once the investor reaches age 70.5.

Constructing an IRA that accomplishes your financial planning goals is an area where a financial advisor can add tremendous value. Be sure to work with an independent fee only financial planner who has a fiduciary commitment to his clients, so you are sure to purchase quality, low cost investments that are in your best interest.

How do 403(b) and 457 Plans Compare to 401(k)s?

403(b) plans, also known as tax sheltered annuities (TSAs), and 457 plans are quite similar to 401(k) plans. Both plans allow employees to defer income and benefit from tax deferred growth, and both plans enable employers to provide matching contributions. 403(b)s and 457 plans, like 401(k)s, have a 2009 contribution limit of $16,500 with an additional $5,500 “catch-up” contribution available to employees over 50 years of age. In most cases, withdrawals from both plans before the age of 59.5 will be subject to a 10% penalty. Lastly, required minimum distributions (RMDs) are required from both accounts once the investor reaches age 70.5.

403(b) accounts, however, are only available to public educational systems and certain tax-exempt organizations. Meanwhile, 457 plans are only available to certain government entities. These plans are attractive to nonprofit and government employers because they are not technically qualified employer retirement plans, so employers can offer these plans to all employees, particular groups, or just individual employees whom the employer wants to benefit.

Public education systems and tax-exempt organizations also have the ability to offer Roth 403(b)s, which lack the benefits of an initial tax deduction, but offer tax-free growth. All 403(b) plans can invest in three types of assets:

1. Annuity contracts (both fixed and variable)
2. Mutual funds
3. Life insurance

An employee who participates in an employee-sponsored 403(b) plan cannot also participate in a 401(k) account. However, 457 plan participants do have the ability to make additional contributions to other employer-sponsored plans. Thus, certain government employees have the ability to contribute as much as $16,500 to their 457 plan, and an additional $16,500 to a 401(k).

What do I Need to Know About my 401(k)?

A 401(k) plan enables employees to defer receiving and paying taxes on a percentage of compensation. The salary reduction amount is deducted from the employee’s paycheck and contributed to a retirement fund, where it accumulates earnings tax-deferred until it is distributed. Tax deferral is advantageous in that it reduces the employee’s annual tax liability, and pre-tax contributions to retirement accounts grow faster than post-tax contributions due to the effect of compounding.

To encourage employees to participate in a company 401(k), many employers make contributions to employee plans in addition to the employee’s contribution. The employer may make automatic contributions to all employee plans, or match employee contributions to individual plans. Employer contributions are sometimes subject to a vesting schedule, meaning the employee must stay with the employer for a certain period of time to have claim to the employer’s additions. In 2009, employees can contribute up to $16,500 to their 401(k) plan, and individuals over the age of 50 can make an additional “catch-up” contribution of $5,500.

Employees should note that an employer 401(k) is not an investment in and of itself. A 401(k) is only an investment vehicle that grants tax deferral, so employees must invest in stocks, bonds, money market funds, and mutual funds within the 401(k). An average 401(k) has about 20 investment options from which an employee may choose.

Employees should only contribute long-term investment funds to their 401(k). With only a handful of exceptions, funds withdrawn from a 401(k) before the employee reaches age 59.5 will be subject to a 10 percent penalty. Income taxes are deferred until money is withdrawn, at which time the funds will be taxed as ordinary income. Once investors reaches age 70.5, they are required to start taking required minimum distributions (RMDs) from their 401(k)s. This enables the federal government to collect tax revenue from the deferred funds.

After leaving an employer, an employee has several options as to what to do with a 401(k). If desired, the 401(k) can stay intact, and it will continue to grow tax-deferred until distributed. Frequently, an employee’s best option when leaving an employer is to roll the 401(k) into an IRA, which opens up a world of investment options and makes record-keeping simple.

In 2006, Roth 401(k)s became available, although employers are not required to offer these plans. Employees do not receive a tax deduction for contributing to a Roth account, but all the money is tax-free upon withdrawal. If an employee believes he or she will be in a lower tax bracket now than when the funds are withdrawn, a Roth account would be a valuable option.

Studies indicate employees who seek the advice of a financial planner constantly obtain superior investment performance within their 401(k). Speak to a fee only financial advisor to maximize the growth in your employer-sponsored retirement plan.

Is Ordinary Income Different from Capital Gains?

Earned income (typically from employment) is considered ordinary income. In 2009, ordinary income tax rates range from 10 to 35 percent. An individual’s marginal tax rate is the percent of the last dollar made during the year that must go towards taxes. It’s important to note that a taxpayer’s marginal tax rate is not applied to every dollar earned during the year. Examine the following chart, which illustrates the federal tax schedule for married individuals filing jointly in 2009.

• 10% on the income between $0 and $16,700
• 15% on the income between $16,700 and $67,900; plus $1,670
• 25% on the income between $67,900 and $137,050; plus $9,350
• 28% on income between $137,050 and $208,850; plus $26,637.50
• 33% on income between $208,850 and $372,950; plus $46,741.50
• 35% on the income over $372,950; plus $100,894.50

As the chart indicates, all income up to $16,700 will be taxed at 10 percent, and only income between $16,700 and $67,900 will be taxed at 15%. This layering of tax rates creates a distinction between a taxpayer’s marginal and effective tax rates. If a couple earned $75,000 in a year, they would be in the 25 percent marginal tax bracket, but their actual federal tax bill would be $11,125 (calculated by subtracting $67,900 from $75,000 and multiplying the result by 25 percent, then adding $9,350). Thus, the couple’s effective federal tax rate would be 14.83 percent ($11,125 divided by $75,000).

Marginal rates are used to calculate how much tax can be saved by increasing deductions. A taxpayer in the 25 percent marginal tax bracket will save 25 cents in federal tax for every dollar spent on a tax-deductible expense, such as mortgage interest.

Capital gains tax is applied to most items purchased and sold for investment purposes. For the purposes of this writing, the items most applicable to capital gains taxes are stocks, bonds, money market accounts, and property. When a capital asset is sold, the difference between the selling price and the basis (usually what was paid for the asset plus the costs of any improvements made) is subject to capital gains tax.

Capital gains or losses are further classified as short-term and long-term. An asset that was owned for 12 months or less is considered to be a short-term asset, and any gains from the sale of short-term assets are taxed at ordinary income rates. Long-term assets are owned for more than 12 months, and qualify for taxation at favorable capital gains tax rates.

Capital gains tax rates are lower than ordinary income rates in order to give investors an incentive to invest in the economy. In 2009, taxpayers in the 10 or 15 percent marginal tax brackets qualify for the generous capital gains tax rate of 0 percent, while taxpayers who are in the 25 percent or higher marginal tax brackets pay a capital gains tax of 15 percent.

Your financial planning efforts should always consider tax implications. Recruit an independent fee only financial planner who prefers to work closely with your tax preparer.

What are Target-Date (Lifecycle) Funds?

Target date funds (also called lifecycle funds) are mutual funds that link an investment portfolio to a particular time horizon. In fact, most target date funds have a date attached to their name. This date should be correlated with a particular event in the investor’s life, most usually their expected retirement date. These funds are becoming more and more common in company 401(k) plans.

Target date funds are unique in that they are actually fund of funds, meaning the target date fund invests in a collection of mutual funds. This is done for diversification purposes. For instance, a target date fund will usually be made up of mutual funds that specialize in large, mid, and small cap stocks, international stocks, and even corporate and government bond funds. As a fund of funds, a target date’s expense ratio is heavily impacted by the expense ratios of the underlying funds.

Target date funds are designed to automatically scale back the level of investment risk in a portfolio as the investor ages. Young investors, not intending to retire until 2040, probably prefer to be aggressive while retirement is not on the horizon, but become more and more conservative as retirement approaches. Target date funds accomplish this goal automatically. As the date gets closer to the target date, the fund will usually begin selling stocks and purchasing bonds and money market instruments, making the portfolio continually more conservative.

It should be noted that a fund does not cease to exist when the target date is reached. The fund of funds will continue to operate as usual after reaching the target date. That date simply measures how aggressive or conservative the fund should be at any point in time.

Before investing in a target date fund, be aware of the implications of using a “one-size fits all” approach to investing. The target date fund may not scale back the aggressiveness of a portfolio as quickly as some investors would like, while being too conservative for others. This is a serious issue not present when an individual utilizes a portfolio of individual stocks, bonds, or mutual funds where they have more control over the portfolio’s overall level of risk.

As usual, it would be wise to converse with an independent fee only financial advisor to more fully understand the benefits and drawbacks of target-date funds.

How are ETFs Different From Mutual Funds?

Exchange traded funds (ETFs) are similar to mutual funds in that they are registered with the SEC as an investment company, and they pool investor’s money into a basket of securities such as stocks, bonds, and money markets. However, ETF shares are different from mutual funds in that they trade on a stock exchange so they can be purchased during a trading day for a specific price. Thus, the value of an ETF is determined by supply and demand, not net asset value. Additionally, this allows ETFs to be sold short or bought on margin (more on these terms later).

An ETF usually tracks a market index, commodity, or economic sector. The most common ETFs track indexes like the S&P 500, but funds can also be purchased that invest only in gold, or companies based in Shanghai. ETFs are not usually actively managed so their expense ratios are generally lower than that of mutual funds. However, an investor must pay the usual commissions associated with buying and selling individual stocks in order to invest in these securities. Thus, ETFs are most appropriate for long-term investing.

ETFs are becoming more common in the financial planning profession. Speak to a certified financial planner (CFP) who has a fiduciary obligation to do what is in their clients' best interests to learn whether ETFs are an appropriate investment for your portfolio.

What Should I Look For In a Mutual Fund?

A mutual fund is an investment management company that pools the money of investors and hires an investment advisor to invest that money in an attempt to achieve a financial objective. Mutual funds can invest in stocks, bonds, money markets, or other securities, and may be designed for current income, capital appreciation, or capital preservation. A mutual fund must make its purpose clear, and actively pursue that purpose. For instance, a large-cap mutual fund must invest 80% of its assets in large-cap stocks.

When an investor purchases or sells a mutual fund, he or she does not pay the fund’s price at the time of the order. Instead, the price paid is usually calculated at the end of the trading day. To calculate its net asset value, a mutual fund will add up the value of all its assets and divide that figure by the total number of shares of the fund.

There are several items to evaluate when identifying an appropriate mutual fund. First, an investor should seek not only top performing funds, but should look for funds that fit a predetermined investment strategy. An investor looking for growth would not benefit from purchasing even the top performing capital preservation fund. Further, it wouldn't be beneficial for an investor to own three top performing international funds only to have a portfolio that isn't adequately diversified.

Once an investor identifies an appropriate type of mutual fund, long-term performance should be closely examined. Many funds have superior performance over one or three year periods. Look for funds that have superior performance over five and ten year periods. Be sure to create an “apples to apples” comparison between funds. For example, compare the performance of a small cap value fund only to that of other small cap value funds. Ideally, look for a fund in the top 25 percent of its category over a three, five, and ten year period.

When shopping for a mutual fund, an investor should also closely examine a fund’s expenses. First, NEVER pay a sales charge (also called a load) to purchase a fund. Also, pay particular attention to something called the expense ratio, which is the sum of a fund’s operating expenses, management fees, and hidden fees (called 12b-1 fees) as a percentage of fund assets. The average expense ratio of a US stock fund is around 1.3 percent. You should be able to identify quality funds with an expense ratio of less than 1%.

Lastly, be sure to examine the manager’s tenure, which is how long he or she has had their job. You don’t want a new money manager gaining experience with your money. Additionally, a new fund manager had nothing to do with the long term performance of the fund, rendering those numbers irrelevant. If possible, look for a fund manager with at least 10 years of experience.

Identifying superior mutual funds is an area where working with an independent fee only financial planner is crucial. Fee only financial advisors (ideally NAPFA members) have a fiduciary obligation to do what is best for their clients. Thus, they will focus on finding top investment options for their clients, rather than on the products that will pay the financial advisor the largest commission.

Should I Utilize Money Market Accounts?

Money market securities are generally very safe investments which produce a relatively low return. These accounts are most appropriate for temporary cash storage or a short-term investment fund. Money market investments always have a maturity of less than one year, and in many cases, less than 30 days. Certificates of deposits (CDs) and treasury bills are good examples of money market securities. These investments are usually purchased in denominations of at least $1,000.

Money market investments are considered to be very liquid, and consequently, are usually included with cash on an individual’s or a company’s balance sheet. Their liquidity and relative safety make them an appropriate investment within an individual’s emergency fund. All investors should have an emergency fund consisting of between three and six months worth of expenses. This fund should only be used in emergency situations, such as a medical emergency or a loss of a job. An emergency fund should be established before any other type of investing.

Speak to a financial planning profession to learn more about the role money market accounts should have in an investment portfolio.

Common Stock – Value, Growth, Large, Small?

Common stock (frequently referred to as equity) represents ownership in a corporation. Stock owners participate in the profitability of a company by receiving dividends, which is the distribution of a company’s profits (usually quarterly). As a company grows, its dividends commonly increase, motivating investors to pay more for the stock. This appreciation of a stock’s value is another way investors profit from stock ownership. Historically, dividends have accounted for approximately 40% of a stocks return, and the other 60% has come from appreciation.

Common stock owners have the ability to vote in elections for a company’s board of directors. If the company goes bankrupt, common shareholders only receive what remains after bond holders and preferred stock holders have been paid. This makes equities more risky to own than bonds, but stocks frequently rewards investors with higher returns over the long run.

Value stocks generally have low price-to-earnings ratios, and are considered to be undervalued in relation to other equity investment options. Traditionally, value stocks pay out the majority of their earnings in dividends. Investors buy value stocks at low prices, and hope their prices increase.

Growth stocks have a high price-to-earnings ratio, and usually pay either a small or no dividend because earnings are constantly reinvested into the company. This allows the company to grow at a faster rate. Investors buy growth stocks at high prices and hope their prices go even higher.

Of course, companies come in various sizes, as measured by market capitalization (number of common shares multiplied by the price of the stock). Generally, a small company is a firm with a market cap of less than $2 billion. A mid-sized company is a corporation with a market cap between $2 billion and $10 billion. Lastly, a large company has a market capitalization above $10 billion. Smaller companies are usually considered to be a more risky investment, and thus, traditionally have provided a higher return than large cap stocks.

Stocks have a place in every investment portfolio, if for nothing other than diversification benefits. Speak to an independent financial planner who can help allocate your assets between stocks, bonds, and cash.

Preferred Stock - Stock or Bond?

Preferred stocks are securities with characteristics of both stocks and bonds. Like a bond, preferred stock has a fixed dividend that it will pay to owners each year. Also like a bond, preferred stock owners do not have the ability to vote on the management of a company. Lastly, because preferred stocks pay a fixed dividend, the value of a preferred share fluctuates more from changes in interest rates than from the actual performance of the company that issued the stock.

However, preferred stocks do not have a maturity date like bonds. Additionally, if a company fails to pay a dividend on its preferred stock, it does not mean the company is bankrupt like the failure to repay a bond would indicate. A company can chose to skip a dividend payment on its preferred shares, but all unpaid dividends on preferred stock must be paid prior to payment of common stock dividends. In this way, preferred stock owners always receive dividend payments before common stock shareholders.

Preferred stocks have a place in some financial planning efforts, but be sure your financial advisor adequately explains the functionality of the asset before investing.

What are the Different Types of Bonds?

Various entities issue bonds to borrow money. Of course, corporations issue bonds to increase their cash flow. If a corporation goes bankrupt, it may not be able to repay its outstanding loans.

The largest sector of the bond market is U.S. Treasury obligations (treasure bills, notes, and bonds). These securities are backed by the full faith of the U.S. Government, and are thus free from default risk. However, because the risk of these securities is reduced, returns are often diminished. Treasury bills (short-term securities) are zero-coupon bonds, meaning they do not produce semi-annual coupon payments. Zero-coupon bonds are usually purchased at a discount (for example, $950) and the purchaser receives the face value ($1,000) on the maturity date. Treasury bonds and notes (intermediate to long term) are similar to other bonds in that they pay a semi-annual interest payment. Although interest rates offered on treasury securities are usually lower than other bond options, interest earned on these investments are exempt from state and local income taxes.

Treasury inflation-protection securities (TIPS) are bonds that provide investors with a rate of return that is adjusted for inflation. If an investor expects significant inflation or wants to insure that the purchasing power of a portfolio will not be reduced by inflation, TIPS would be an appropriate investment.

Municipal bonds are issued by state and local governments. There are two types of munis. General obligation bonds are backed by the taxing power of the government entity. Revenue bonds are serviced by specified revenue-producing projects such as a toll road. If the project fails to produce revenue, the municipality doesn’t have to repay the loan. Consequently, revenue bonds are more risky than general obligation bonds. Both types of municipal bonds are generally exempt from federal income tax and local tax if the investor lives in the state that issued the bond. Thus, these investments are frequently attractive to individuals in high tax brackets.

Like stocks, bonds can be purchased individually or through a bond mutual fund. A bond fund simply invests in a portfolio of individual bonds. The bond fund manager collects the coupon payments from the individual bonds and reinvests the money into other bonds. When a bond matures, the face value of the maturing bond is most often simply reinvested into a new bond. Bond funds do not have a stated maturity date or coupon, and bond fund investors do not receive a repayment of principle until the fund is sold.