investing for your future part 2: mutual funds and tax-deferred investments
TRANSCRIPT
Investing For Your Future 2:
Mutual Funds and
Tax-Deferred Investments
Barbara O’Neill, Ph.D., CFP®, AFC, CHC
Rutgers Cooperative Extension
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
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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