TOOLS FOR INVESTING
Once you have a good savings foundation, you may want to diversify your assets among different types of investments. Diversification can help smooth out potential ups and downs of your investment returns. Investing is not a get-rich-quick scheme. Smart investors take a long-term view, putting money into investments regularly and keeping it invested for five, 10, 15, 20 or more years.
Bonds — Lending Your Money
When you buy bonds, you are lending money to a federal or state agency, municipality or other issuer, such as a corporation. A bond is like an IOU. The issuer promises to pay a stated rate of interest during the life of the bond and repay the entire face value when the bond comes due or reaches maturity. The interest a bond pays is based primarily on the credit quality of the issuer and current interest rates. Firms like Moody’s Investor Service and Standard & Poor’s rate bonds. With corporate bonds, the company’s bond rating is based on its financial picture. The rating for municipal bonds is based on the creditworthiness of the governmental or other public entity that issues it. Issuers with the greatest likelihood of paying back the money has the highest ratings, and their bonds will pay an investor a lower interest rate. Remember, the lower the risk, the lower the expected return. A bond may be sold at face value (called par) or at a premium or discount. For example, when prevailing interest rates are lower than the bond’s stated rate, the selling price of the bond rises above its face value. It is sold at a premium. Conversely, when prevailing interest rates are higher than the bond’s stated rate, the selling price of the bond is discounted below face value. When bonds are purchased, they may be held to maturity or traded.
Savings bonds. U.S. savings bonds are government-issued and government-backed. There are different types of savings bonds, each with slightly different features and advantages. Series I bonds are indexed for inflation. The earnings rate on this type of bond combines a fixed rate of return with the annualized rate of inflation. Savings bonds can be purchased in denominations ranging from $50 to $10,000.
Treasury bonds, bills and notes. The bonds the U.S. Treasury issues are sold to pay for an array of government activities and are backed by the full faith and credit of the federal government. Treasury bondsare securities with terms of more than 10 years. Interest is paid semiannually. The U.S. government also issues securities known as Treasury bills and notes. Treasury bills are short-term securities with maturities of three months, six months or one year. They are sold at a discount from their face value, and the difference between the cost and what you are paid at maturity is the interest you earn. Treasury notes are interest-bearing securities with maturities ranging from two to 10 years. Interest payments are made every six months.
Treasury Inflation Protected Securities (TIPS) offer investors a chance to buy a security that keeps pace with inflation. Interest is paid on the inflation-adjusted principal. Bonds, bills and notes are sold in increments of $1,000. These securities, along with U.S. savings bonds, can be purchased directly from the Treasury through Treasury Direct at www.treasurydirect.gov. Some government-issued bonds offer special tax advantages. There is no state or local income tax on the interest earned from Treasury and savings bonds. And in most cases, interest earned from municipal bonds is exempt from federal and state income tax. Typically, higher income investors buy these bonds for their tax benefits.
Stocks — Owning Part of a Company
When you buy stock, you become a part owner of the company and are known as a stockholder, or shareholder. Stockholders can make money in two ways — receiving dividend payments and selling stock that has appreciated. A dividend is an income distribution by a corporation to its shareholders, usually made quarterly. Stock appreciation is an increase in the value of stock in the company, generally based on its ability to make money and pay a dividend. However, if the company doesn’t perform as expected, the stock’s value may go down.
There is no guarantee you will make money as a stockholder. In purchasing shares of stock, you take a risk on the company making a profit and paying a dividend or seeing the value of its stock go up. Before investing in a company, learn about its past financial performance, management, products and how the stock has been valued in the past. Learn what the experts say about the company and the relationship of its financial performance and stock price. Successful investors are well informed.
Mutual Funds — Investing in Many Companies
Mutual funds are established to invest many people’s money in many firms. When you buy mutual fund shares, you become a shareholder of a fund that has invested in many other companies. By diversifying, a mutual fund spreads risk across numerous companies rather than relying on just one to perform well. Mutual funds have varying degrees of risk. They also have costs associated with owning them, such as management fees, which will vary depending on the type of investments the fund makes.
Before investing in a mutual fund, learn about its past performance, the companies it invests in, how it is managed and the fees investors are charged. Learn what the experts say about the fund and its competitors.
Stocks, bonds and mutual funds can be purchased through a full service broker if you need investment advice, from a discount broker, or even directly from some companies and mutual funds. Remember, when investing in these products:
- Find good information to help you make informed decisions.
- Make sure you know and understand all the costs associated with buying, selling and managing your investments.
- Beware of investments that seem too good to be true; they probably are.
Invest for Retirement
Have you ever thought about how much money you will need when you retire? Will you save enough today to meet your future needs at prices higher than today’s due to inflation? Many people don’t save enough for retirement. For example, suppose you are 20 years old and would like to have $1 million when you retire at age 65. If you can invest $13,719 today, it will grow to $1 million over the next 45 years if it earns a constant 10 percent return, compounded annually. You never have to add another dime to your initial investment.
INDIVIDUAL RETIREMENT ACCOUNTS
An individual retirement account (IRA) lets you build wealth and retirement security. The money you invest in an IRA grows tax-free until you retire and are ready to withdraw it. You can open an IRA at a bank, brokerage firm, mutual fund or insurance company. IRAs are subject to certain income limitations and other requirements.
You can contribute up to $4,000 a year to a traditional IRA, as long as you earn $4,000 a year or more. A married couple with only one person working outside the home may contribute a combined total of $8,000 to an IRA and a spousal IRA. Individuals 50 years of age or older may make an additional “catch-up” contribution of $1,000 a year, for a total annual contribution of $5,000. Money invested in an IRA is deductible from current-year taxes if you are not covered by a retirement plan where you work and your income is below a certain limit.
You don’t pay taxes on the money in a traditional IRA until it is withdrawn. All withdrawals are taxable, and there generally are penalties on money withdrawn before age 59½. However, you can make certain withdrawals without penalty, such as to pay for higher education, to purchase your first home, to cover certain un-reimbursed medical expenses or to pay medical insurance premiums if you are out of work.
A Roth IRA is funded by after-tax earnings; you do not deduct the money you pay in from your current income. However, after age 59½ you can withdraw the principal and any interest or appreciated value tax-free.
Many companies offer a 401(k) plan for employees’ retirement. Participants authorize a certain percentage of their before-tax salary to be deducted from their paycheck and put into a 401(k). Many times, 401(k) funds are professionally managed and employees have a choice of investments that vary in risk. Employees are responsible for learning about the investment choices offered. By putting a percentage of your salary into a 401(k), you reduce the amount of pay subject to federal and state income tax. Tax-deferred contributions and earnings make up the best one-two punch in investing. In addition, your employer may match a portion of every dollar you invest in the 401(k), up to a certain percentage or dollar amount.
As long as the money remains in your 401(k), it’s tax-deferred. Withdrawals for any purpose are taxable, and withdrawals before age 59 ½ are subject to a penalty. Take full advantage of the retirement savings programs your company offers—and understand thoroughly how they work. They are great ways to build wealth.
If you’re self-employed, don’t worry. There is a retirement plan for you. A qualified plan (formerly referred to as a Keogh plan) is a tax-deferred plan designed to help self-employed workers save for retirement.
The most attractive feature of a qualified plan is the high maximum contribution—up to $42,000 annually. The contributions and investment earnings grow tax-free until they are withdrawn, when they are taxed as ordinary income. Withdrawals before age 59 ½ are subject to a penalty.
Check the IRS web site — www.irs.gov — for current information on tax-deferred investments.
Investing in Your House
You know you are ready to buy a home when you have reduced your debt, increased your savings and have a sizable down payment saved. By doing these things, you will have equity in your home from the start.
Equity is the difference between the market value of a house and the balance on a mortgage. As you pay your mortgage, equity is increased. Over time, a house may rise in value—generating more money if you choose to sell it. Knowing that the more equity you have in your house, the wealthier you will be, it may be wise to take a 15-year mortgage rather than the more traditional 30-year mortgage. This will enable you to own your house in 15 years. Of course, you will make higher monthly payments on your mortgage, but you will build equity quicker and ultimately pay less interest.
Start Your Own Business
You can also start and invest in your own business as part of a wealth-creation plan. This requires planning, know-how, savings and an entrepreneurial spirit. Starting a small business can be risky, but it is one of the most significant ways individuals have to create personal wealth.