investing for your future part 2: mutual funds and tax-deferred investments

Investing For Your Future 2:

Mutual Funds and

Tax-Deferred Investments

Barbara O’Neill, Ph.D., CFP®, AFC, CHC

Rutgers Cooperative Extension

oneill@aesop.rutgers.edu

Webinar Objectives

• Review several basic investing concepts

• Discuss mutual funds and ETFs

• Discuss choosing financial advisors

• Discuss tax-deferred investment products and

investing for retirement

Investing For Your Future

www.investing.rutgers.edu

Categories of Investments

• Ownership (Equity): Own something – Stocks and stock funds

– Real estate and REITS (real estate investment trusts)

– Collectibles

– Commodities

– Variable annuities

• Loanership (Fixed-Income): Lend money – Bonds and bond funds

– Certificates of Deposit (CDs)

– Fixed annuities

Resource: http://www.extension.org/pages/39847/what-are-ownership-and-

loanership-types-of-investments

The Risk-Reward Trade-Off

Source: Garman/Forgue, PERSONAL FINANCE, Fifth Edition

Risk (Chance of Loss)

• There is no such thing as a “perfect” investment (risk-free, tax-free, high return)

• All investments have some type of risk

• Risk can be caused by:

– Inflation

– Changes in the economy

– Political uncertainty (home and/or abroad)

– Business failure

– Interest rate changes

http://www.finra.org/Investors/SmartInvesting/AdvancedInvesting/ManagingInvestmentRisk/

Techniques to Offset Risk

• Diversification – Putting your money, “your eggs,” into several “baskets” (e.g.,

stocks, bonds, cash, real estate)

– http://www.sec.gov/investor/pubs/assetallocation.htm

– http://www.investopedia.com/articles/02/111502.asp#axzz1rH9rDBUo

• Dollar-Cost Averaging

– Investing regular amounts at regular intervals regardless of price

– Examples: $50 on the 1st of every month or 6% of your gross income every payday

– Lowers average share price cost over time

– https://www.americancentury.com/calculator/dollar_cost_averaging_calculator.jsp

Investing in Mutual Funds

• Mutual Fund = investment vehicle offered by

investment companies to those who wish to:

– Pool money with other investors

– Receive automatic diversification

– Indirectly buy stocks, bonds, and other securities

– Have buy/sell decisions made by fund manager

• Many mutual funds are selected in retirement

savings accounts

How a Mutual Fund Works

Source: Personal Finance (Garman & Forgue), Houghton Mifflin

Why Investors Select Mutual Funds

• Professional Management

– Find out who fund manager is and years of experience

• Diversification

– Investor’s funds are used to purchase a variety of investments (shares of many different companies)

• Low Cost

– Often $1,000 or less to open account; $100 for deposits

Biggest Disadvantages: No control over fund distributions and taxes and no guarantee against market losses

Resource: http://www.investopedia.com/ask/answers/10/mutual-funds-advantages-disadvantages.asp#axzz1uJ6PEFFD

Mutual Fund Videos

• http://www.youtube.com/watch?v=fpcvJiO-rjk&feature=related

(What is a Mutual Fund?)

• http://www.youtube.com/watch?v=v8tK6LuOP3E&feature=topics

(How Mutual Funds Work)

Net Asset Value (NAV) Current market value of assets held by a mutual fund

– Net Assets = Fund Assets - Liabilities

– NAV (price per share) is calculated at the close of trading

• Net assets divided by number of outstanding shares

– Determines price for purchase and sale of fund shares

Example: $52,500,000 value of fund net assets

3,500,000 number of shares = $15 per share

Open-End Mutual Funds

• Majority of all mutual funds

• Shares issued and redeemed by investment company at request of investors

• Investors free to buy and sell shares at net asset value (NAV)

• No broker or stock exchange required

• Wide variety of services

• Automatic deposits and withdrawals

• Exchanges among family of funds

Resource: http://www.investopedia.com/exam-guide/cfa-level-1/alternative-investments/open-closed-end-funds.asp#axzz1uJ6PEFFD

Load vs. No-Load Mutual Funds • Front-End Load Fund

– Sometimes called an “A” fund

– Commission (sales charge) up to 8.5% • Average = 3 to 5%

– Purchased through brokerage firms or registered representatives

• No-Load Fund

– No up-front sales charge

– No salespeople

– Investor deals directly with the investment company via

800 number or Web site

Resource:

http://finance.yahoo.com/funds/how_to_choose/article/10

0601/Load_vs__No-Load_Funds

Load vs. No-Load Mutual Funds

• Back-End Load Fund

– “B” fund

– Fee charged upon withdrawal of funds (1-5%)

– Fee generally decreases on a sliding scale depending on number of years shares are held

• Fee disappears after about 5-6 years

• Knowing your holding period is key factor

Resource: http://www.morningstar.com/InvGlossary/back_end_load_definition_what_is.aspx

Mutual Fund Expenses

• Management Fee

– Charged yearly (.25%-1.5% of NAV average) based on a percentage of assets under management (AUM)

• 12b-1 Fee

– Fee to defray advertising and marketing costs

– Cannot exceed 1% of AUM per year

• Expense Ratio

– Total expenses associated with management fees and operating costs of the fund

Resource: http://www.sec.gov/answers/mffees.htm

Typical Mutual Fund Fees

Source: Focus on Personal Finance, McGraw-Hill (2010)

Types of Mutual Funds

Types of

Mutual Funds

Stock Funds Bonds Funds Other Funds

Source: Focus on

Personal Finance,

McGraw-Hill (2010)

Stock Mutual Funds Types of

Mutual Funds

Stock Funds Bonds Funds Other Funds

Index funds Match index holdings

% U.S. vs.

International

Small-cap

Mid-cap

Global

International

Large-cap

Growth

Equity income

Price growth vs.

Dividend Income

Aggressive Growth

Socially responsibleInvest in socially

responsible firms

Economic SectorsSector funds

Company Size

Regional

Source: Focus on

Personal Finance,

McGraw-Hill (2010)

Bond Mutual Funds Types of Mutual

Funds

Stock Funds Bonds Funds Other Funds

High-yield

Intermediate

Corporate bonds

Intermediate U.S.

Gov't bonds

Long-term

corporate bonds

Long-term U.S.

gov't bonds

Municipal bonds

Short-term

corporate bonds

Short-term

U.S.gov't bonds

Source: Focus on

Personal Finance,

McGraw-Hill (2010)

Other Mutual Funds

Types of

Mutual Funds

Stock Funds Bonds Funds Other Funds

Money Market Funds

Asset Allocation Funds

Balanced Funds

Lifecycle Funds

Fund of Funds

Source: Focus on Personal

Finance, McGraw-Hill (2010)

Risk and Returns on Mutual Funds

Source: Personal Finance (Garman & Forgue), Houghton Mifflin

Family of Funds

One investment company manages a group of

mutual fund portfolios

– Each fund has a different financial objective

– Exchange privileges allow movement from one

fund to another within the family with low or no

charge

– Listed alphabetically in newspapers

Names of popular investment companies?

Managed Funds vs.

Index Funds • Managed Fund fund manager makes all decisions

regarding securities in the fund’s portfolio

• Index Fund securities held by the fund replicate those contained in a specific index like the Standard & Poor’s (S&P) 500

Resources: http://abcnews.go.com/Business/PersonalFinance/index-funds-actively-managed-funds-best/story?id=8866429

http://money.cnn.com/2007/06/11/pf/expert/expert.moneymag/index.htm

Sources of Mutual Fund Information

1. Internet sites provide current values

– http://finance.yahoo.com

– www.morningstar.com

– www.smartmoney.com

2. Mutual fund companies’ Internet sites

– www.troweprice.com

– www.vanguard.com

3. Professional Advisory Services

– Lipper Analytical Services

– Morningstar, Inc.

– Value Line

4. Financial advisors (stock broker, financial planner, etc.)

Mutual Fund Prospectus

Prospectus – a mutual fund’s investment

objectives and policies must be stated in

this document

Two Types:

• Traditional prospectus (long)

• Profile prospectus (short)

Resource:

http://www.sec.gov/answers/mfprospectustips.htm

Example of a Mutual Fund Objective

“The fund invests with the objective of capital

growth. Although income is considered in the

selection of securities, the Fund is not

designed for investors seeking primarily

income rather than capital appreciation.”

Other Sources of Fund Information

• Mutual Fund Annual Report

– Performance, investments, assets and liabilities

• Financial Publications

– Business Week, Forbes, Kiplinger's Personal

Finance, WSJ, Consumer Reports, and Money

• U.S. Securities and Exchange

Commission (An Introduction to Mutual

Funds):

http://www.sec.gov/investor/pubs/inwsmf.htm

3 Ways Money Grows With Funds

Income

– Earnings paid from dividends and interest

– Taxed as ordinary income

Capital Gains Distributions

– Distributions when the fund buys and sells securities

– Taxed as long-term gains

Capital Gains (or Losses)

– Capital gains (or losses) when an investor sells shares

at a different price than price originally paid

– Taxed as short- or long-term gains

Reinvesting Fund Distributions

Source: Personal Finance (Garman & Forgue), Houghton Mifflin

Five Key Factors to Consider

• Fund objective

• Fees and expenses (for type of fund)

• Historical performance

• Investment policies relative to personal risk

tolerance

• Minimum initial and subsequent deposits

Resource: http://articles.marketwatch.com/2007-08-

26/finance/30744309_1_style-and-discipline-funds-

with-sales-charges-mutual-funds

Follow “The Rule of Three” Fund Characteristic Fund #1 Fund #2 Fund #3

Objective

Performance

Expense Ratio

Required Deposit

Investment Policies

Mutual Fund Record-Keeping

• Most recent prospectus and annual report

• Copy of original application form

• Annual account statements

– For as long as you hold investment + 6 years

• Articles about the fund, manager, etc.

Resource: http://www.nytimes.com/2011/01/09/business/mutfund/09record.html

Mutual Fund Resources

• Mutual Fund Education Alliance: http://www.mfea.com/

• Mutual Funds Resource Center: http://www.mutualfundsresource.com/

• Investment Company Institute: http://www.ici.org/

• Finish Rich (Author David Bach): http://www.finishrich.com/free_resources/fr_mutualfunds.php

Exchange-Traded Funds (ETFs)

• Invests to replicate the composition of a specific securities index

– Example: Standard & Poor’s 500 Index

• Performance mirrors index performance

• Low management fees

• Trade on exchanges throughout the day like stock

• Prices determined by supply and demand

• Can be traded with limit orders

ETF Resources

• http://www.sec.gov/answers/etf.htm (Securities and

Exchange Commission)

• http://www.investopedia.com/terms/e/etf.asp#axzz1uJ6PEFF

D (Investopedia)

• http://www.extension.org/pages/63274/monthly-investment-

message:-march-2012 (eXtension)

• http://www.dummies.com/how-to/content/how-etfs-differ-

from-mutual-funds.html (Investing for Dummies book)

• http://www.ici.org/etf_resources (Investment Company

Institute)

Ways to Buy Investments

• Through brokerage firms

– Full-service broker

– Discount broker

– Online broker

• Through banks and their bank-affiliated partners

• Directly from a company that issues them

Resources: http://www.investopedia.com/articles/basics/03/051603.asp#axzz1uNbWsmWK

http://beginnersinvest.about.com/cs/brokers1/a/042501a.htm

Investment Clubs

• Meet regularly to learn about investing and how to

buy/sell securities

• The focus is (or should be) education

• Typically 10 to 15 members that form a partnership

• Big drop-off in membership in recent years

Resources:

http://www.nolo.com/legal-encyclopedia/joining-

investment-club-30224.html

http://www.betterinvesting.org

Finding a Financial Advisor

Resources:

http://www.fpanet.org/PlannerSearch/PlannerSearch.aspx

Financial Planning Association (FPA)

http://www.napfa.org/

National Association of Personal Financial Advisors (NAPFA)

http://www.cfp.net/

Certified Financial Planner Board of Standards, Inc.

http://www.finra.org/Investors/ToolsCalculators/BrokerCheck/ FINRA Broker Check

Costs of Financial Advice

• Fees

• Commissions

• Combination of fees and commissions

• Percentage of account value (assets under management)

• Hourly rate

• Annual retainer fee

Resource: http://moneyover55.about.com/od/findingqualifiedadvisors/a/sixfinancialplannerfees.htm

Choosing Financial Advisors

• Get referrals from friends or other professionals

• Check credentials and complaint history

• Interview at least three professionals

• Check out references

• Set up face-to-face meetings

• Ask questions

• Ask yourself “Do I trust this person?”

• Make a decision

Questions for Financial Planners

• How long have you been a financial

planner?

• What related experience do you have?

• What are your professional credentials and

affiliations?

• What is your investment philosophy?

• How will we work together?

More Questions for

Financial Planners • What services do you offer?

• What can I expect from you?

• What will it cost and how are you paid?

• Who will work with me?

• May I see a sample financial plan?

• Are you registered with state or federal

regulators?

Taxable vs. Tax-Deferred Investing

27,6

00

31,3

00

48,3

00

58,6

00

75,8

00

98,8

00

112,2

00

157,9

00

160,3

00

244,7

00

$0

$50,000

$100,000

$150,000

$200,000

$250,000

10yrs 15yrs 20yrs 25yrs 30yrs

Taxable Returns (at 28%)

Tax-Deferred Returns

Garman/Forgue, PERSONAL FINANCE, Fifth Edition, Tax-

Sheltered Returns are Greater than Taxable Returns

(Illustration: 8% Annual Return and $2,000 Annual Contribution)

Calculator: http://www.calcxml.com/do/inv07

Salary Reduction Plans

401(k), 403(b), 457, and TSP

• Workers elect to reduce their salary (up to maximum amount allowed)

• Employee contributions are tax-deferred

• Some employers match a portion of workers’ contribution

• Funds invested in stocks, bonds, mutual funds, etc. offered by plan

Resource: http://www.irs.gov/retirement/sponsor/article/0,,id=155347,00.html

Individual Retirement Arrangements

Regular (Traditional) IRA

– Maximum $5,500 deposit in 2013; must have earned income ($6,500 if age 50+ with $1,000 catch up)

– Worker must select own IRA investment products

– Contribution may be tax-deductible, depending on tax filing status and income

– Interest accumulates tax-deferred until withdrawal

– May begin withdrawing (penalty-free) at 59 ½

– Must begin withdrawing at 70 ½

– Withdrawals are taxable income

Individual Retirement Arrangements Roth IRA

– Maximum $5,500 deposit in 2013; must have earned income

– Worker must select own IRA investment products

– Contributions are not tax deductible

– Maximum income limits for eligibility to make contributions

– Withdrawals are tax-free and penalty-free, if:

» You are at least age 59 ½

» Account is open at least 5 years

– Can convert a Regular IRA into a Roth IRA; must pay taxes due

Individual Retirement Arrangements

• Rollover IRA

– Traditional IRA allowing transfer of all, or a

portion, of distribution from an employer

retirement plan or other IRA

• Spousal IRA

– Contributions for a nonworking spouse if filing a

joint return

– Same contribution limits as workers’ Roth or

Traditional IRAs

Small Business Retirement

Accounts

• Simplified Employee Pension (SEP-IRA)

– Funded by freelancers and small business owners

– Annual contributions up to $51,000 (2013)

– Simplest retirement plan for the self-employed

• SIMPLE Plans

– $12,000 worker contribution + $2,500 catch-up (2013)

• Keogh Plans

– Annual contributions up to $51,000 (2013)

– Most difficult small business plan to administer

Annuities • Contract with an insurance company (check rating)

• Investor makes lump sum deposit or periodic deposits

• Insurance company provides payments for life or a fixed period

• Sold by many types of financial professionals

• Purchased with after-tax dollars

• Money compounds tax-deferred

Resources:

http://www.actuarialfoundation.org/programs/investing.shtml

http://www.sec.gov/answers/annuity.htm

http://www.moneychimp.com/calculator/annuity_calculator.htm

Immediate Annuities

• Purchased with lump sum of money – Retirement account balance

– Life insurance benefit

– Settlement

• Provides fixed income starting soon after purchase

• In return for lump sum, annuity guarantees fixed income for life or specified period (depending on payment option)

Resource: http://www.extension.org/pages/9662/investing-unit-7:-annuities

Deferred Annuities

Invest Now - Collect Later

• Purchase Options – Single premium (lump sum)

– Flexible payment (installment payments over time)

• Two Types

– Fixed - earns an interest rate established for a set time

• Like a tax-deferred CD

– Variable - earnings dependent on selected investments called subaccounts (e.g., stock)

• Like tax-deferred mutual funds

Risks and Benefits of Annuities

Risks

• Complexity

• Not FDIC insured

• High surrender charges

• High expenses on

average

• Age restriction for

penalty-free withdrawals

• Financial soundness of

annuity issuer

Benefits

• Can provide

guaranteed income

for life

• Tax-deferred growth

of principal

• Some low-cost

providers exist

Investing For Retirement

Retirement Withdrawal Consensus

• Backed up by 2 decades of research

• Withdraw 4% of retirement assets annually with annual inflation adjustment

• High probability of money lasting 30 years

• Example: $200,ooo of savings

– $8,000 in year 1 ($200,000 x .04)

– $8,240 in year 2 ($8,000 + $8,000 x .03 [$240])

• Assumes that 50% of portfolio is in stock

• More conservative investors should withdraw less (e.g. 3%)

How Much Needs to be Invested?

Let’s Use Some Numbers

For every $1,000 of desired monthly income (above SS and/or pension), you need $300,000 saved

– $300,000 x .04 = $12,000

– $12,000 ÷ 12 = $1,000

• $2,000/month = $600,000

• $3,000/month = $900,000

• $4,000/month = $1.2 million

• $5,000/month = $1.5 million

Beware: Retirement Frauds

• Walk away from solicitations that “guarantee” consistently high returns

• Don’t be rushed into legal or investment decisions

• AARP study: “At risk” activities” associated with investment fraud

– Opening and reading junk mail

– Attending free lunch seminars

– Entering drawings to win a free prize

– Inviting salespeople into your home

In Summary • Mutual funds provide professional portfolio management

• Net asset value is the price to buy or sell fund shares

• All mutual funds have fees; the lower, the better

• A prospectus is a key mutual fund screening tool

• Follow the “Rule of Three” to select funds, advisors, etc.

• ETFs are a hybrid between stocks and index funds

• Annuities provide regular income for a specified period

• Retirement savings can be calculated and planned

Action Steps

• Review the format of mutual fund listings in a newspaper

• Read a mutual fund prospectus

• Visit one or more mutual fund company Web sites

• Explore one or more sources of investment information

• Explore one or more sources of mutual fund information

• Investigate investment choices in employer retirement plan

• Start or increase retirement plan savings

Questions? Comments

Experiences?

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