This is the second post in the Investing Basics series, written by Jennifer from To My Girlfriends. I’m thrilled to have her writing this series and I hope you enjoy it as much as I do. Make sure to check out Part 1.
I briefly touched on mutual funds in my last post, but let me put it in layman’s terms. A mutual fund is a professionally managed portfolio of different equities, such as stocks, bonds and cash, designed to give a small investor the opportunity to invest in those equities with a small amount of cash. The mutual fund manager takes the money you give him and decides the best way to allocate those funds. If you are in a bond fund, then the majority of your dollars will be allocated to bonds. If you are in a large cap mutual fund, then the majority of your dollars will be allocated to large cap stocks ie. McDonald’s, Kimberly Clark, Caterpillar, etc. (We will discuss “large cap” at a later time.) Also, remember the manager will not be fully invested, they will keep some money aside in cash for various reasons…sometimes because they sold off a position and just haven’t re-invested the cash elsewhere yet.
When I was recommending mutual funds to former clients some of them would get so confused that an IRA they were invested in was actually a mutual fund just dressed up into a retirement vehicle. Are you confused by that too? Well, let’s see if we can remedy that.
*Note, for you more advanced people I do know there are retirement vehicles that aren’t mutual funds, but for my purposes I am sticking with this view.
You can purchase a “regular” mutual fund. There are tax implications with a “regular” mutual fund. When the funds you invested gain in value, which is the goal hopefully, then you will pay taxes on that gain when you remove the dollars from the fund. Also, you will receive a 1099-DIV from your brokerage firm if your mutual fund invested in any companies that paid out a dividend that year. You probably didn’t receive a check for the dividend payout because you probably checked the box “reinvest dividends.” It is a very common practice unless you need the dividend income to live on. It’s also a great way to increase your portfolio value.
Now here is the confusing part, I think. Your “regular” mutual fund is great for some medium-term goals, but if you have long-term goals, as most of do, your advisor has probably suggested an IRA. That is an Individual Retirement Account. The money you put into that account is intended to stay there until you are 59 ½ . The IRS will penalize you if you remove it prior to that age, unless you qualify for one of their exceptions. There are 2 types of IRAs, the Traditional and the Roth.
The Traditional IRA lets you deduct your contribution off your taxes which means this type of IRA is “tax-deferred.” Since you didn’t pay taxes on your contribution you will pay them later along with paying taxes on all the earnings on said money.
A Roth IRA, on the other hand, is not deducted off your tax return. All the money you put into the IRA and all it earns are tax-free. The penalty applies to both the Traditional and the Roth if you take the money out prior to age 59 ½.
If you happen to be lucky to work for a company that offers a 401(k), good for you and even better if they “match.” A 401(k) is another retirement investment vehicle. You contribute to your company’s plan. The dollars you put in are considered a salary reduction. In other words, you don’t pay taxes on that part of your salary. This is another tax-deferred plan.
The last retirement vehicle to discuss is the 403(b). I inadvertently called it a 503(b) in my last post. I’m sorry about that. Acronyms and numbers trip me up too. A 403(b) is structured very similarly to a 401(k) but it is offered to certain employees of public schools, tax-exempt organizations and ministers. (http://www.investopedia.com/terms/1/403bplan.asp#axzz261f0XQxU)
All of the plans have benefits and you can have more than one of them at a time. They do have different contribution limitations though. If you exceed the limits, you will be penalized so consult your advisor or www.irs.gov or shoot me a note and I can discuss this with you.
There are even retirement plans for the self-employed, but the above 4 cover most of the population and their options.
To summarize, 3 of the plans I discussed are tax-deferred because you get to deduct the contributions from either your salary or your taxes and 1 of the plans is tax-free because you don’t deduct the contributions.
One thing to remember, an IRA is either yours or your spouses’ (if that fits). Even if you don’t have gainful employment outside the home, but your spouse does, you are eligible to contribute to one.