Last time, we told you about debt securities, specifically bonds. If you missed it, look for the article online at www.ChesapeakeCurrent.com along with others in our Live Secure series.
This issue, let’s go over some other types of investments and additional important need-to-know lingo.
Annuities: These are contracts with an insurance company. The insurance company invests your money and promises to pay you interest and principal after a period of time, usually in fixed installments, for your lifetime. When you buy an annuity, you are investing after-tax dollars. The growth that occurs in your investments inside the annuity is not taxed until you start making withdrawals of the money. Most people hope to be retired and in a lower tax bracket at that time. You can purchase fixed-rate or variable-rate annuities. Investing through an annuity means relying on the insurance company to do what is required and to be there for you when you retire.
Dollar Cost Averaging: Many people invest a fixed amount of money into particular investments at regular intervals. For example, each time she gets paid, Joan invests a percentage of her paycheck in IBM stock. Sometimes, her fixed amount buys her more shares, sometimes less, depending on the price of IBM shares at the time. Her strategy is called dollar cost averaging.
Capital Gains. When you buy a security at a low price and sell it at a high price, you must pay tax on the difference. If you buy and sell within one year, the money you make becomes ordinary income to you and is taxed at ordinary income tax rates. If you buy in one year and sell in the next, the money you make is taxed at a lower capital gains level of 20%.
Investment Returns. Investments involve risk. To evaluate investment returns, you need to know something about risk. Most people mistakenly avoid risk by sticking with something they know, which is not always good advice. For example, if you have a choice in your employer-sponsored 401(k) plan of picking your employer’s stock as an investment, you may be tempted to choose only that stock as your investment and avoid learning about the other investment choices you have. Avoid the temptation to take this “easy” way out. Putting all your investment eggs into one stock is simply silly and can lead to disastrous results if the company goes bankrupt or suffers a loss in its stock price. The way to handle risk appropriately is to use the adage “don’t put all your eggs in one basket.” This is otherwise known as asset allocation and we’ll discuss this again later, but clearly if you diversify and choose different investments, one investment may go bankrupt while another may outperform your expectations.
People use the phrase” expected rate of return.” The U.S. government securities are the most stable in the world—when the government says it’s going to pay you 5% interest and give you your principal back in five years, you can rely on this as a virtual certainty. Since government securities are virtually risk free, they pay a low rate of interest. In other words, your investment return decreases as the risk of loss decreases—a low risk of loss means lower returns on your investment. Expected rate of return has little meaning applied to other investments. Mutual funds, by law, can only state past performance and cannot predict future performance—you can find out what the rate of return of a particular mutual fund has been on the web sites of most popular mutual funds or brokerage firms over the past ten years, but no one can predict what the rate of return will be in the future.
Cash and Cash Equivalent Investments. Cash includes the crinkly stuff and cash-equivalent investments. These are investments that combine high quality with liquidity (the ability to sell off quickly) such as short-term interest bearing securities and deposit accounts. These investments provide safety of principal and current interest. Certificates of deposit, money market deposit accounts, and Series EE government bonds are cash-equivalent instruments that may be purchased at a bank. The Federal Deposit Insurance Corporation (FDIC) insures bank passbook savings accounts, money market deposit accounts and certificates of deposit up to a maximum of $250,000 per account. For credit unions, there is similar government sponsored insurance. If you want to obtain FDIC deposit insurance for more than $250,000, you must open another account titled in a different way since the insurance follows the title on each account.
Series EE bonds or savings bonds are purchased at 50% of the face amount of the bond (from $50 to $10,000), limited to $30,000 face value per year for any one person. The bonds increase in value based on a floating rate of interest equal to 85% of the average return on 5-year U.S. Treasury securities. These securities can’t be redeemed before six months, meaning you have to leave your money in for at least that length of time. No Federal tax is required to be paid on the interest until you sell the bond. And, if you use the proceeds to pay college tuition, you may not have to pay any tax on the interest income.
Money market mutual funds are not FDIC insured. Because of this, they pay a higher rate of interest than the bank insured cash-equivalent investments. However, due to the regulations governing the makeup and disclosure required of money market mutual funds, investments in these funds are considered to be secure and therefore cash equivalent. Securities that are held in a money market mutual fund portfolio generally have a “term to maturity” of 30-90 days. This means the securities are of short “duration” and the ratings on the securities are high. These investments are obtained from mutual funds companies. Your bank also may have such funds available for investment.
About the Author: Lyn Striegel is an attorney in private practice in Chesapeake Beach and Annapolis. Lyn has over thirty years experience in the fields of estate and financial planning and is the author of “Live Secure: Estate and Financial Planning for Women and the Men Who Love Them (2011 ed.).” Nothing in this article constitutes specific legal or financial advice and readers are advised to consult their own counsel.