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10 Things You Need To Know About FAFSA
It is October which means the beginning of the financial aid season for college bound students. The FAFSA, short for Free Application for Federal Student Aid is the first step in the process for financial aid. The FAFSA form became available for families to fill out on October 1 and must be filled out in order to be considered for financial aid. Each year the US Department of Education doles out almost $30 billion in grants and another $100 billion in loans. Here are 10 things you need to know about the FAFSA. 1. The goal of the FAFSA is to determine your EFC (Expected Family Contribution). The output of the FAFSA is your EFC which is the amount the US Dept. of Education calculates you should be able to contribute towards the cost of college for your family in the upcoming school year. This does not mean you have to pay that much towards the cost of college just that this will be the number used to determine your eligibility for various forms of need-based aid. Here is how it works. Say your EFC comes back at $30,000. This amount will be the same for each school. School one has a cost of attendance (COA) of $28,000. Since the formula indicates you should have the resources to pay the full amount and will not be a candidate for need based aid. But at school two, which has a COA of $55,000, you have a demonstrated need of $25,000 which leaves you as a candidate for need based aid. 2. The FAFSA information is shared with individual schools so they can prepare your financial award package. On the online FAFSA form, there is a section where you can provide the code of the various schools you want the FAFSA information to be sent. The Dept. of Education will share this data with those schools allowing them to prepare a financial award package specific for you. 3. The primary drivers of the EFC calculation are income and certain assets. Both the parents and the student’s data is taken into consideration. For most people, their income will the primary driver. Retirement funds and home equity are not considered which for most people are their two largest assets. Non-retirement investment accounts, vacation or rental properties, and the value of a business are considered though. In general, assets in the parent’s name are considered at a rate of 5.6% while those belonging to the student are considered at 20%. So the general rule of thumb is that an advantage to have assets in the parent’s name than the child’s. 4. In the case of divorced parents, the only parent who needs to report income and assets is the custodial parent. Even if the non-custodial parent provides more than 50% of the financial support and/or claims the child as a dependent for taxes, only the custodial parent needs to report data for the FAFSA. In addition, if the custodial parent has remarried, it is still only the custodial parent who needs to report data and not the step parent. 5. 529 plans are treated as an asset of whoever is listed as the account owner. In most cases, these belong to the parents and are assessed at the 5.6% rate. If a 529 plan is owned by a grandparent it is not counted as an asset on the FAFSA but once funds are taken out and used for the student then that will be treated as income for the student and will be assessed at 20%. 6. When filling out the FAFSA you will use the income reported on your prior, prior year tax return. This can be a bit confusing but here is how it works. If you are applying for financial aid for the 2021-22 school year you will use the data from your 2019 tax return so at the time the aid will be received it will be based on the prior, prior year. If you file the form this fall the 2019 return will be your most recent return. 7. During the process of filling out the online form you will have the option to use a data retrieval tool to get your IRS tax return information. This will greatly reduce the amount of time required to fill out the form. You can expect the process to take 1-2 hours depending upon the complexity of your information if you use data retrieval. 8. You may need to file a separate form depending upon the schools you are interested in applying to. FAFSA is widely used by most public schools but many private schools use a form called CSS that has a slightly different formula it uses and some of the assets that are not considered by FAFSA will be considered on the CSS. 9. You will need to refile the FAFSA every year you want financial aid. This is not something you do prior to your freshman year and have the totals carry over each subsequent year. Your financial details will vary year by year so might your ability to qualify for needs based aid. 10. Everyone should be urged to fill out the form regardless of whether you think you are a need based candidate or not. The FAFSA is the basis for determining other types of aid as well including some non-need based aid. For instance, to qualify for the Unsubsidized Federal Direct Loan you will need to have filled out the FAFSA and this is a loan that is available to everyone regardless of your financial situation. So even if you are sure you won’t get grants that is no reason to not fill out the form. If you are unsure of how to complete the form or have questions please reach out to info@7thstfinancial to get the guidance you need. Make sure you have the correct information so you are in position to get financial aid you have coming to you.
In my last entry, we began discussing the topic of portfolio risk management, specifically discussing portfolio allocation or the amount of risk within a portfolio. In this installment, we will continue the risk management discussion but the focus here will be on portfolio diversification. Many people are familiar with the term diversified portfolio but for those of you who aren’t it is basically the concept of spreading your investments around. For those of you who have been around long enough to remember the classic case is Enron, which was a huge and very successful energy company in the late 1990s and early 2000s. The problem with Enron was that they committed fraud with their accounting and the profits they were reporting were non-existent. The employees of Enron received their pension all in Enron stock so when the fraud was exposed, the company filed for bankruptcy and the stock went to zero. All of the employees lost their pension which was all tied to Enron stock. While Enron might be an extreme example, it certainly highlights the risk of having a concentrated position in any single asset. There is more to diversification though then just making sure you invest in more than one company. The goal of having a diversified portfolio is that no one event leaves you’re a major portion of your portfolio at risk. Now the truth is you can’t diversify away all risk. There are some things that happen that are on such a scale that they impact everything. The financial crisis is a prime example of this as it took down the value of every major asset class. Natural disasters, wars, and other acts of God are examples of other things where it is hard to diversify away risk. As an investor, you must understand that things change within the economy, world politics, consumer tastes, and technological advancements that can impact the fortunes of a company, an entire industry, or even a country. The key goal with diversification is to not have one of these changes put too much of your investment portfolio at risk. Below are the different ways you want to try and diversify your portfolio to help manage these risks as they occur. Security diversification This is basically the Enron scenario I laid out above. Any single company can experience a significant downturn due to poor management decisions, financial mismanagement, scandal, or one of the other reasons listed above. Blockbuster Video is another good example of this. We all used to go to Blockbuster to rent our videos but then along came a little upstart called Netflix which changed the way we consumed this content. Blockbuster failed to adjust to this new technology and consumer tastes and now has one remaining store while Netflix is worth over $200 billion. A study by the University of Michigan concluded that it takes 25-50 individual holdings to have a diversified portfolio. In addition to spreading out your investments between multiple companies the other rule is to try and not have any single holding be more than 5% of your total portfolio. This can be a challenge for those that work for a company where the 401k match is company stock, offer an employee stock purchase plan (ESPP) that allows workers to purchase the stock at a reduced price or receive company stock as part of their total compensation. In these cases check your company rules on when they allow you to sell the stock. These rules were put into place as a result of the Enron scandal. Be aware of how concentrated you are getting and do the best you can to keep this in check. Sector diversification The S&P 500 is made up of 11 unique sectors. Think of these as different areas of business. The five biggest sectors are Technology, Health Care, Consumer Discretionary, Communication Services, and Financials. Each sector contains companies that are related by the broad type of business they conduct. For instance, the Consumer Discretionary sector includes Amazon, Home Depot, McDonald’s, Nike, and Starbucks. These companies would most likely take a hit in a recession as people would likely look to spend less money on home improvement, eating out and new clothing but would tend to do well if the economy is going strong. Another sector such as Technology or Consumer Staples might still perform fine in a recession as they are less reliant on individuals having discretionary income. Industry diversification This is just a deeper dive into the sector diversification. Say for example you have investments in Facebook, Twitter, and Snap. These are all part of the much broader Technology sector but largely all play specifically in the social media space. The risk here is that something could come along that could change the outlook of all social media companies. For instance, in the past couple of years, Congress has had several issues with various social media companies. If they were to pass a law that hindered their business models the stock prices of all social media companies could take a hit. This new law though may not have any impact on other tech companies like Apple, Salesforce, Nvidia and Adobe that don’t have a social media component. Capitalization diversification Companies that you can invest in come in all sizes. While they are big enough companies to have issued stock and be listed on a public market they run a vast range in their market size (number of shares x stock price). Within the S&P 500 alone which is home to ‘large’ companies, Apple currently has a market cap of over $2 trillion while Macy’s comes in at roughly $1.5 billion which is less than 1% the size of Apple. Different forces can be beneficial or harmful to companies of different sizes. Coronavirus, which was generally hard on all companies has widely been viewed as being much harder on smaller companies in general than large companies. On the other hand, Congress could pass a tax law that could target large companies by having them pay a higher corporate tax rate. The market has classifications of mega cap, large cap, mid cap, and small cap. Spreading your investments out between the various market cap classifications is key to having a diversified portfolio. Geographic diversification This concept involves spreading your investments across different geographies around the world. Different countries will go through economic ups and downs at different times. The common geographic classifications are domestic, international, and emerging markets. In the early to mid-2000s the US stock market was returning an average of 14% from 2003-2007 but Emerging Markets returned an average of 37% over that same time. Spreading your investments around and not just being focused on US investments only would have let you participate in those explosive Emerging Markets returns. Now had you thought you needed to go all-in on this Emerging Markets trend you would have been rudely greeted with a 53% loss in 2008 which was the worst performing segment of that year. Investment style diversification Another way companies are classified is where they are in their lifecycle. The common designations here are growth and value. Growth companies (current examples include Amazon, Google and Facebook) tend to be earlier in the lifecycle and are experiencing rapid growth in sales and/or income. Value companies (think Coca Cola, McDonald's, and Verizon) tend to be more well established and with more stable revenue and income or can be companies that have experienced a downturn and whose stock can be purchased at a relative bargain. Growth companies have enjoyed superior investment performance since the mid-2010s, but in the early 2000s value stocks outperformed growth by a good margin. Bonds In the last post, I talked about how mixing in bonds or other fixed income assets help an advisor with portfolio allocation. Well, there is also diversification within fixed income investments. Fixed income assets come in different maturity lengths. Bonds or Treasury securities, for example, can range from 1 to 30 years before they mature. Longer term debt pays higher interest rates but is more vulnerable to changes in interest rates. Another way to diversify your fixed income holdings is by credit quality. Many fixed income instruments are debt that has been issued and you are receiving interest payments and then eventually your principal. The higher the credit quality of the debtor the lower interest rates you will receive. Lower quality debtors need to pay a higher rate of interest but are more susceptible to default if there is an economic downturn. Summary A well diversified portfolio will have a little bit of everything. This may keep the portfolio returns from achieving the peak numbers one could reach if they were in the hot segment of the moment but that would require being invested 100% in that segment of the market and we have just discussed the risks of doing that. This approach will tend to smooth out your returns as even if part of your portfolio is encountering issues you should have plenty of other areas doing just fine. Most of us achieve this diversification by investing in mutual funds or ETFs in our investment accounts. For example, an S&P 500 index fund alone will give you access to a pretty well diversified portfolio all by itself. This gives you access to a wide variety of companies, sectors, industries and many of these large companies have an international presence. In addition, most of us have access to an international fund in a 401k account to help get better access to non-US based companies. Some plans may have access to a total market fund which would have holdings in all categories. Diversification along with allocation goes a long way to managing the risks of your investment portfolio. Hopefully, you found this informative and helpful. If you are wondering if your investments are properly aligned to manage risk and would like help I would love to hear from you. Feel free to reach out to or schedule a conversation here.
Welcome to the latest blog from 7th Street Financial where I discuss various topics related to personal finance with the goal of providing insight you can use for yourself or at the very least get you thinking about certain topics and how they might impact you. In this first of two installments on the topic, I will discuss risk management within your investment portfolio. The two primary key concepts covered here will be Risk Tolerance and Risk Capacity. These two items combined help us determine the proper allocation of one’s portfolio. The second installment will cover the risk elements that drive to having proper diversification within the portfolio. One of the primary tenants of investing is risk vs. reward. In order for us to get larger returns on our investments we need to take larger risks. Historically, the larger share of your investments that are in equities the better your long term return. Equities though tend to be more risky than fixed income investments from the perspective that they are more prone to sharp declines. This risk of holding equities smooths out over the long term as short term ups and down tend to result in a long term upward trajectory. The following two charts show year by year returns for the S&P 500 which highlights that there is occasional downside risk while most years are positive and the second chart is the historical long term trend which reflects long term growth. Managing the risk of short term declines can be critical depending upon where you are at in your investing lifecycle. Many of us are at least somewhat familiar with the concept of Risk Tolerance which is basically a measure of how much risk are you comfortable having in your portfolio. As an advisor, I use a series of questions that I pose to clients to determine their appetite for incurring risk. These questions are geared to help an advisor understand how comfortable someone is with investments, their mindset with investing, and how you would react to several potential investment return scenarios. For example, a question might be “if the stock market is down 25%, what would you do?” and the options would be something like 1. Buy more; 2. Stay the course; 3. Sell some of the investments; 4. Sell all of the investments. The person who sees this as an opportunity to buy more is demonstrating a high risk tolerance where the person inclined to sell is not. This is something that needs be continually monitored. Life experiences and situations may change the way an investor feels about risk. It is one thing to answer a theoretical situation on paper but it is another to see you IRA drop by 30%. People have a tendency to be slightly more conservative in real life than on paper. The goal with this series of questions is to have the information needed to construct a portfolio for the investor that they can be comfortable with. One key to know as the investor is that the most important thing is to just be truthful in your responses. Advisors shouldn’t care if you profile out as more conservative or aggressive. There is no right or wrong on that scale. The advisor should just want to do what is right for you. If an advisor pressures you into a portfolio you are not comfortable with that is a warning sign you and the advisor are probably not a good fit. The last thing I want is for a client to be losing sleep at night because they can’t handle the ups and downs of a turbulent market. Risk tolerance is a measure of an investor’s ability psychological ability to handle risk. There are no neat categories that groups of people fit in. Younger investors can be just as conservative with risk as older investors and vice versa. In addition to Risk Tolerance, advisors also consider a lesser known concept known as Risk Capacity. This is a measure of the amount of risk an investor can take on to achieve their goals and may or may not line up with your Risk Tolerance. Also, you may have different Risk Capacities for different financial goals. The basic measurement of one’s Risk Capacity is time. The longer you have before you need the money for a given goal the higher your Risk Capacity is and as your time horizon shortens before you need money the lower your Risk Capacity becomes. For example, when you are age 30 and saving for retirement you have a very high Risk Capacity as you have potentially 30 plus years to grow your investments and plenty of time to ride out any ups and downs in your returns. Compare that to when you are three years away from retirement and you no longer have time to recover from a major market downturn which results in you having a very low Risk Capacity. As I stated earlier, you might have different Risk Capacities for different financial goals. I found myself in this position this past year. Take a couple who is 50 years old planning to retire at age 62 with a 16 year old child. Since they have 12 years to go to retirement they still have a fairy high risk capacity in terms of retirement but if they have been saving for their child to go to college they have a very low risk capacity for those funds as they would have almost no time to recover from a market downturn. As a result, I left my retirement funds alone but moved the funds in our 529 plan to a much more conservative investment in 2019 when we were two years out from needing the funds. At that point I was less concerned with trying to get substantial growth than protecting what we had already saved and was willing to take a much lower return in exchange. When Covid-19 hit my retirement funds certainly took a hit but they have time to recover but our 529 plan just took a minor dip which, thankfully, was not enough to alter our plans. Events like Covid-19, the Financial Crisis of 2008 are why we make these moves to get more conservative as our time horizon gets closer. Next, what do you do if your risk capacity and risk tolerance are at odds with each other? Take the situation I discussed above with our college savings. My risk tolerance is fairly high but our risk capacity was low due to our short time horizon. When it comes to risk management with your investments choose the more conservative option in a case like this so even though risk tolerance is high the low risk capacity wins out. The same holds true in the case of a low risk tolerance and high risk capacity. This might happen if there is a 30 year old who has decades to save for retirement but gets nervous when there is volatility in the market. Even though there is plenty of time to recover from any downturns I don’t want the client to be uncomfortable watching the daily ups and downs if that makes them uncomfortable. A slightly more conservative portfolio makes sense in this case. The combination of Risk Tolerance and Risk Capacity drives the proper allocation in an investor’s portfolio. You are probably familiar with people talking about a 70/30 or 60/40 mix or something similar. That is in reference to the allocation of equity versus fixed income holdings in a portfolio with a 70/30 meaning 70% of the portfolio is in equities and 30% in fixed income. The higher the equity holdings the riskier the portfolio. So, let’s put everything together and walk through a couple of examples. Say we have our 30 year old and their retirement savings. They have moderate risk tolerance and high rick capacity at this stage of their life which might put them in a 70/30 portfolio for now. As they get within 10 years of retirement they can start to gradually become more conservative. By the time they hit retirement a 50/50 portfolio may be appropriate. This is similar to the approach I took with the 529 plan I mentioned earlier. When our daughter was born the portfolio was nearly 100% equities. Since the entire life of the investment is only 18 years we moved through the stages much quicker. By age 10, the portfolio mix was closer to 70/30, by age 13 it was closer to 60/40 and at age 16 it was 40/60. Remember that as an investor there is no right or wrong answer for where you land on the spectrum. Over the long term a higher equity allocation historically has resulted in higher returns but that may not be worth the mental anxiety or the risk of short term downturns for you. If your allocation isn’t the same as your family, friends or that is okay. You need your portfolio to work for you and your goals which are unique to you. That wraps up this first installment on portfolio risk management. I hope you found this informative and maybe learned something you can use for yourself. Look for the next installment portfolio risk management where I will cover diversification. If you have any questions about where you should be from an allocation standpoint and if your portfolio is properly matched feel free to reach out to or visit our website at to schedule a no cost 30 minute discussion on your situation. 7th St. Financial Inc. (“7th St. Financial”) is a registered investment adviser offering advisory services in the State of Minnesota and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. The presence of this website on the Internet shall not be directly or indirectly interpreted as a solicitation of investment advisory services to persons of another jurisdiction unless otherwise permitted by statute. Follow-up or individualized responses to consumers in a particular state by 7th St. Financial in the rendering of personalized investment advice for compensation shall not be made without our first complying with jurisdiction requirements or pursuant an applicable state exemption. All written content on this site is for information purposes only. Opinions expressed herein are solely those of 7th St. Financial, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation. All investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.
Financial Planning 101 - Mega Backdoor Roth Conversions
Want to hear about a way to make the largest contribution to a Roth plan on an annual basis regardless of your income? Welcome to the latest in the Financial Planning 101 series where I cover various topics related to personal finance and try to educate you about how these items could be relevant to you. I have been focusing lately on all things Roth including the basics of Roth plans and the different types of Roth conversions. The last installment was on Backdoor Roth conversions. Today’s topic is the Mega Backdoor Roth Conversion. The Basics Most workplace retirement plans today are defined contribution plans. This means that the plan allows for certain contributions but has no guaranteed return or payout on the back end. In other words, the employee takes on the risk of return. Compare that to a defined benefit plan (think pension plan) where it is the payout that is guaranteed and the employer has to figure out how much to contribute to meet their obligation. Under a defined contribution plan there is a maximum of $57,000 that can be contributed to the plan during the year. This amount covers all contributions including the employee and employer contributions. Very few employees will ever hit this cap based on their normal contributions. Even someone making $300,000 may max out their 401k contributions of $26,000 (assuming age 50 or over), add in a 5% employee match of $15,000 and that still leaves $16,000 remaining before hitting that cap. Some plans allow for additional after-tax contributions to be made into the plan beyond the $26,000 maximum for 401k as long as you are under the overall $57,000 cap. And that is where the Mega Backdoor Roth comes into play. The Conversion These additional contributions aren’t part of a Roth even though they are after-tax contributions. Usually, these additional contributions will still be part of your 401k plan but will be segregated and identified as after-tax. To make the conversion you would select a rollover of just these after-tax funds directly to a Roth account. Ideally, you would do this on an annual basis if possible. To do this you would need a Roth account already established with an outside financial institution. Alternatively, you can wait until you leave the company and roll over the funds then. Tax Handling Unlike other Roth conversions where you recognize the amount being converted as income and have to pay income taxes on that amount, this type of conversion is handled much differently. Since the amount being converted is already after-tax contributions the amount being converted is not recognized as income and therefore no additional taxes are owed. Once the funds are in the Roth account they are treated the same as any other funds in a Roth. That means tax-free growth and tax-free distributions later on assuming you meet the criteria for qualified distributions. Since the contributions are made after-tax, they retain Roth like status even while not being in a Roth account. The earnings on these contributions are a different story though. The earnings will be treated like 401k earnings and will be taxed at the time of conversion. That is why ideally you can make the conversions prior to leaving the job so the contributions won’t have time to accumulate much in gains. Remember, that once the funds are converted to a Roth all gains are tax-free. The Benefits 1. Allows high income earners a chance to make Roth contributions despite being above the income limits. 2. Being able to make these after-tax contributions is preferable to investing funds in a taxable brokerage account. A taxable account has both after-tax contributions and the gains are taxed as well. With these after-tax contributions, the gains will be tax-free once in the Roth account. The Limitations Much like the traditional Backdoor Roth Conversion discussed in my previous post, there are some big caveats with this type of conversion that can make this a difficult option for many to participate in. 1. You need to have the financial means to make this high level of contributions. Before doing non-Roth after-tax contributions you would need to first max out your annual 401k contributions. I would also recommend making contributions to a traditional IRA or Roth IRA before choosing this option. It can be difficult for many people to have additional funds for retirement savings once they have maxed out these other accounts. 2. Your 401k plan must allow for these after-tax contributions to be made and not many plans do (43% according to a 2017 survey). This is the biggest impediment to most people being able to take advantage of this because without this provision in your workplace plan it is a deal breaker. To see if your plan allows these contributions you will need to look at the Summary Plan Description (SPD) for your employer’s plan. 3. To get the maximum benefit from this you will want to be able to make in-service distributions so that you can do the rollovers on whatever time schedule you please. Again, this is not an option that many plans offer and you will need to refer to your SPD to see what your plan allows. If in-service distributions are not offered in your plan then you can still do the conversion when you leave that employer. Conclusion The Mega Backdoor Roth Conversion is not something that many people can take advantage of, but for those that can, it can be another powerful tool in your financial planning toolkit. Max out your other retirement contributions first and if you have the remaining capacity to set aside retirement savings check with your employers SPD to see if they allow for extra after-tax contributions. That puts a wrap on my series on Roth related items. I hope you found this series informative as Roths are an under utilized yet extremely beneficial investing option for many people. The next installments will focus on other areas of investing. As always, if you have any questions about your finances and you want to understand if any given topic is appropriate for you please reach out to to have a free discussion regarding your situation. 7th St. Financial Inc. (“7th St. Financial”) is a registered investment adviser offering advisory services in the State of Minnesota and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. The presence of this website on the Internet shall not be directly or indirectly interpreted as a solicitation of investment advisory services to persons of another jurisdiction unless otherwise permitted by statute. Follow-up or individualized responses to consumers in a particular state by 7th St. Financial in the rendering of personalized investment advice for compensation shall not be made without our first complying with jurisdiction requirements or pursuant an applicable state exemption. All written content on this site is for information purposes only. Opinions expressed herein are solely those of 7th St. Financial, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation. All investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.
In my previous post, I wrote about Roth conversions. The focus there was on the traditional type of conversion where an investor moves funds from a traditional IRA to a Roth IRA. Today, I will discuss a different type of Roth conversion called the backdoor Roth conversion. The traditional Roth conversion is suitable and even advisable for a large number of people. The backdoor conversion serves a more narrow audience but can still be a very powerful tool for those in position to take advantage of it. If you try and google a backdoor Roth conversion you will find varying definitions and descriptions. Some will refer to the ‘backdoor’ component as simply converting traditional IRA funds to a Roth which is really just a straight forward Roth conversion that is available to everyone. The backdoor Roth conversion I will discuss here is a way for high income investors to bypass the income limits on making annual Roth conversions. In my post on Roth IRAs, we discussed the annual limit of contributions of $6,000 for people under age 50 as long as their income is under certain limits, currently $206,000 at the highest, depending upon tax filing status. So while traditional Roth conversions are usually made in bulk sums they don’t address the ability to make annual contributions to a Roth plan for high earners. That’s where the backdoor Roth conversion comes into play. Why would someone want to do this? While contributing to a Roth in high earning years may not seem to make much sense due to the high taxes you will have paid on the money contributed, think about what your other options are for investments. Assuming you have maxed out your 401k first, where else do you go? A Roth is a better option than a taxable account which has after tax contributions and capital gains taxes on the back end. I also prefer a Roth to any of the tax sheltered insurance related options such as forms of permanent life insurance and annuities. Here is how it works. Assume your family AGI puts you over the $206,000 threshold for being able to make contributions to a Roth plan. You probably also make too much to make a tax deductible contribution to a traditional IRA. But, you can always make a non-tax deductible to an IRA regardless of your income. So step one is to make that non-deductible IRA contribution. Note, this will be after tax money. Step two, convert this non-deductible IRA amount to your Roth account. So, what are the benefits? This allows a high earner to make annual Roth contributions. No tax owed on the conversion since it was taxed before entering the IRA. Enjoy tax free growth on the converted amount. Provides tax flexibility by allowing a high earner to have not just tax deferred income in retirement. Sounds great, let’s do it! To quote the great Lee Corso, “Not so fast my friend.” There are some major strings tied to the backdoor conversion you need to be aware of before trying one and they are significant. Annual limit on the contribution limit. IRA contributions are limited to $6,000 per year for people under age 50 and $7,000 for those 50 and above. So, for a high earner this can be a somewhat complicated process to go through for a $6,000 contribution. But, that tax free growth can be worth it. Pro-rata rule. This is the big one and can frankly make this a non-starter for some people. The pro-rata rule states that when making a Roth conversion you must make the conversion in the same ratio as what you have in pre-tax vs after-tax money in your IRA. For example, let’s say you have $54,000 in an IRA from a 401k rollover. You now have added you $6,000 after tax contribution and try to do a $6,000 Roth conversion. That leaves you with an IRA balance of $60,000 (90% of which is pre-tax and 10% after tax). The pro-rata rule prohibits you from cherry picking that specific after tax $6,000 for conversion. Instead, your $6,000 conversion is going to be made up of $5,400 pre-tax and just $600 of that after tax contribution. Since 10% of your IRA balance is made up of after tax contributions you are limited to 10% of the converted amount to be after tax. This can be a deal breaker for those that already have large established IRA balances as you will have to recognize the income and pay taxes on the non after tax amount and may only be able to convert a small potion of your after tax contribution. Taxes owed on gains. If there is a lag between the time the after tax contribution is made and the conversion takes place, the principal that was contributed may have gains associated with it. These gains will be considered ordinary income when converted along with their principal. So who should be trying to take advantage of the backdoor Roth conversion? This conversion makes sense for people meeting the following criteria: High income earners Maxed out their 401k and still have funds to invest No previous IRA balance The limitations due to the smaller amounts that are converted and the specific criteria needed to be met for the conversion to be beneficial make this an option that a limited number of people can take advantage of. While the backdoor conversion may not be quite as powerful a tool as traditional Roth conversions due to these limitations, it is still an option for high earners that allows access to annual Roth contributions they would otherwise be prohibited from making and there can be significant value in that. That wraps up our overview of backdoor Roth conversions. I hope you found this informative and helpful for your understanding of personal finances. As always, if you are wondering if this makes sense for you and your specific circumstances please reach out to me at or check out our website at and provide your contact information. Thank you for reading and I hope you check out our next topic which will be on one final type of Roth conversion, the Mega Backdoor Roth Conversion. 7th St. Financial Inc. (“7th St. Financial”) is a registered investment adviser offering advisory services in the State of Minnesota and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. The presence of this website on the Internet shall not be directly or indirectly interpreted as a solicitation of investment advisory services to persons of another jurisdiction unless otherwise permitted by statute. Follow-up or individualized responses to consumers in a particular state by 7th St. Financial in the rendering of personalized investment advice for compensation shall not be made without our first complying with jurisdiction requirements or pursuant an applicable state exemption. All written content on this site is for information purposes only. Opinions expressed herein are solely those of 7th St. Financial, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation. All investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.
In the previous post, I discussed the key facts you need to know about Roth investment accounts. In this installment, we’ll switch to discussing Roth conversions. Specifically, what they are, the benefits of doing one, and when they make sense to do. A Roth conversion is a great tool that savers have at their disposal to take advantage of different tax rates throughout their life. In the previous posts covering traditional IRAs and Roths, we specifically discussed the tax treatment of both contributions and withdrawals. Understanding this is critical to knowing why Roth conversions are a valuable option for you. First, let’s start with understanding what a Roth conversion is. A Roth conversion is the process of moving funds from a traditional IRA account into a Roth IRA and in the process recharacterizing the funds from a tax standpoint. To do this you need to have opened both a traditional IRA account that is funded and a Roth IRA account (this account does not have to be funded). As we learned about traditional IRA accounts, withdrawals are treated as taxable income, and the same applies when doing Roth conversions. Any amount that you convert from a traditional IRA to a Roth will be added to your taxable income for the year and be taxed at your marginal tax rate. For example, if a married couple with a taxable income of $100,000 does a Roth conversion in the amount of $25,000, their taxable income increases to $125,000. As this income is in the 22% range, they would owe $5,512 in income tax on the amount that was converted. So why would someone want to do this if you have to pay $5,500? The reason is that the $25,000 now in the Roth account will grow tax-free and won’t be taxed a t the time of withdrawal either (assuming rules are followed for qualified distributions). That can be a very compelling reason. This $25,000 growing at 6% over 20 years will grow to just over $80,000. This $80,000 is now tax-free for the couple when they need it in retirement. There are other advantages as well to doing Roth conversions: Reduces amount in IRA which in turn reduces future RMDs and the corresponding taxes Roth IRAs are not subject to RMDs so provide flexibility with an option for tax-free retirement income planning Roth IRAs provide a way to pass assets to your heirs without them owing taxes Provides a workaround for IRS income limits on being able to contribute to a Roth This chart below shows the financial benefit of doing a series of Roth conversions and how it shifts the balance over time from the IRA to Roth account and how that will reduce future RMDs and related tax liability. So why wouldn’t everyone do this? One, you need to pay those pesky taxes in the year of the conversion and you may not have the cash to do that. Second, it may not make financial sense, believe it or not, given your current circumstances. Ideally, you can take advantage of Roth reconversions when you are in periods of paying low tax rates. Let’s walk through a few scenarios using our same couple from before. 1. Let’s adjust the couple’s income to $50,000 which is in the middle of the 12% tax rate. Converting $25,000 still keeps them in the 12% tax bracket. Let’s assume they are both 35 years old and that as time goes on their income increases and prior to retirement their income grows to $200,000. Between what they were able to save and Social Security, their retirement income projects to be $175,000 which is in the 24% tax bracket. By doing a Roth conversion when they did they were able to pay 12% in taxes on the conversion to later avoid 24% on the withdrawals. That is a great scenario for doing a Roth conversion. 2. Now let’s assume our same couple is age 50 and are in their peak earning years. Their income has grown to a combined $350,000 which puts them in the 32% tax bracket. They now have an expected $225,000 retirement income. Doing a Roth conversion at this point and paying 32% on the conversion to avoid paying 24% later does not make much sense. 3. Our couple is now making $170,000 and expects to have $125,000 in retirement income. The $170,000 current income is in the 22% tax bracket as is $125,000 retirement income. But, the $25,000 Roth conversion is additional income which pushes their current income to $195,000 and the incremental $25,000 is almost all in the 24% tax bracket. In this case, they would pay the higher rate on almost the entire conversion amount. The basic premise boils down to taking advantage of lower tax rates now compared to projected future higher rates. The best way to do this is when you are in a lower tax paying year to try and fill up the lower tax bracket with Roth conversions. In our first scenario listed above, the couple has $100,000 of taxable income. The 22% bracket goes all the way up $171,500 in 2020 meaning if possible they could convert $71,500 and still be in the 22% tax bracket. Here is a list of times in life that a Roth conversion might make sense: Early retirement. Say you retire at age 60. You are not yet eligible for Social Security and do not have to start taking disbursements from your IRA/401k accounts. This can be a period of lower income and can be a perfect time for Roth conversions. Take a couple that retires at age 62 and is planning to live off money in their savings account and investments from a joint taxable account. The savings money can be used tax free and the taxable account will only result in income to the extent of the capital gains. Say this results in $25,000 in taxable income. That still leaves $55,000 of room to do Roth conversions and stay in the 12% tax bracket. Early career. When starting your career your salary tends to be lower than it will be later in your career and as a result likely puts you in a lower tax bracket. Economic hardship. This one can be tough because at a time when your income is lower due to a job loss or other economic conditions, volunteering to pay additional taxes for a Roth conversion may not seem like a smart thing to do. If other areas of your finances are intact though and you can ride out the temporary dip, the timing might be right. Expected tax increases. In 2018 Congress passed the law to reduce our tax rates. One thing many people may not know is these lower rates are set to expire after 2025. That means all rates across the board may go up at all income levels. Income is at the lower end of the tax bracket. This is especially important when there is a large increase in the rate of the next tax bracket. There isn’t a huge difference between $80,250 up to $326,600 which covers both the 22% and 24% tax brackets. Contrast that with $80,250 which is the tipping point between 12% and 22% brackets. Likewise $326,600 is the tipping point between the 24% and 32% brackets. If your income is at $200,000 you have $126,600 remaining in the 24% bracket to take advantage of conversions. Compare that to if your income is at $315,000 which only leaves $11,600 in the 24% bracket. Any conversion amount greater than $11,600 will be taxed at the much higher 32%. There is one important caveat to know with Roth conversions and it is called the 5 year rule. Any amount converted to a Roth must be in the Roth account for a period of five calendar years in order to avoid the early withdrawal penalty and have earnings taxed. Five calendar years only means that the funds have to be in the account covering five different years not five full years. For instance, a conversion made in December of 2020 covers all of 2020 meaning a withdrawal in January of 2024 counts as year 5. This holds true for each conversion performed. Once an individual turns 59 ½ the five year rule no longer applies. The Roth conversion can be a very powerful option in your financial planning toolkit. If used correctly you can pay a lower income tax rate on your contributions and get to take advantage of the huge benefit of tax free growth. You just need to know when to do the conversion so you can take advantage of the benefits it can provide. If you are interested in understanding if you are a good candidate for a Roth conversion drop us a line at firstname.lastname@example.org. I hope you found this helpful and informative. Look for the next post where I will continue discussing additional forms of Roth conversions, the backdoor Roth conversion, and the Mega backdoor Roth conversion.
Financial Planning 101 - What You Need to Know About Roth Accounts
It has been a while since my last blog post on traditional IRA accounts. There have been quite a few changes in the world since then and I have put a focus on trying to deal with issues related to COVID-19 and its fallout. As a result, the blog activity was put on the back burner. While COVID continues to dominate our national discussion and there is much uncertainty on how and when we can get back to a sense of normalcy, there are planning opportunities that have been created as a result, and those need to be discussed. One of the biggest financial planning opportunities that has been created is the increased potential benefit of Roth conversions. Before getting into conversions, though, let’s understand what a Roth account is first. To do that we’ll discuss how Roth accounts are different from other accounts and the pros/cons of this type of account. Remember that the 401k and IRA account contributions are pre-tax, meaning that the contributions are removed from your income before they figure out the income tax calculation. On the back end though all distributions, including both contributions and earnings, are all fully taxable. With a Roth plan it is just the opposite. Contributions are post-tax but all distributions, including both contributions and earnings, are tax-free. Here is an example of how this works using simple math (actual tax rates and amounts would be different due to tiered tax rates). Say your salary is $100,000 and you want to contribute 10% ($10,000 in this case) to a Roth and are in a 22% tax bracket. Your $100,000 is taxed at 22%, or $22,000, leaving you with an after tax amount of $78,000. The $10,000 Roth contribution then comes out of the $78,000 leaving you with a net of $68,000. In comparison, a 401k would take the $10,000 contribution from the $100,000 leaving $90,000 to be taxed. At 22% this would be $19,800 leaving a net of $70,200. So while the 401k might leave more money in your pocket right away the Roth makes up the difference when you withdraw the funds by not paying taxes at that time. Here’s how it works on the back end. Let’s say in retirement you withdraw $50,000 and are in the 12% tax bracket. If you withdraw the funds from an IRA or 401k you would have to pay 12% in taxes on that $50,000, leaving you with a net of $44,000. If instead the funds were a qualified withdrawal from a Roth IRA or Roth 401k the entire $50,000 would be tax-free leaving a net of $50,000. Qualified Distributions One key thing to note with Roth accounts is that your contributions can always be withdrawn tax-free as you have already paid income taxes on the money used for contributions, but the earnings need to meet certain criteria to be withdrawn tax-free. The Roth account must have been open for at least five years and the individual must be at least age 59 ½. There are exceptions to this which include distributions for the following: certain health insurance and medical expenses; higher education expenses, up to $10,000 towards a first home or to meet an IRS levy. Non-Qualified Distributions Any distributions not meeting the criteria listed above or for one of the exceptions incurs the same penalty as an early distribution from an IRA/401k which is a 10% penalty in addition to the distribution being considered taxable income. Important things to know If your employer offers a 401k plan with a Roth option you can split your contributions between the traditional 401k and the Roth however you choose. One thing to note is that your employer match will be placed in the traditional 401k account. So if you are looking for a specific split between the two types of accounts you will want to take the match into consideration as well. Contribution limits are the same with a Roth 401k as they are a traditional 401k, $19,500 for 2020 plus an additional $6,500 catch up if over the age of 50. This contribution limit can be split between the traditional and Roth accounts. They are also the same for a Roth IRA and a traditional IRA which is $6,000 plus an additional $1,000 if over age 50. There are income limits for being able to contribute to a Roth IRA account. Phaseout ranges are $0-$10,000 if married filing separately, $196,000-$206,000 if married filing jointly and $124,000-$139,000 for everyone else. There are no income limits for contributing to a Roth 401k. When does a Roth make sense compared to other investments? The decision to use a Roth account compared to a traditional IRA/401k account really comes down to current vs. future tax rates. Ideally what you want to do is use whatever type of account today that will help you avoid the higher tax rate you will experience in working years compared to retirement. If your income is lower, and are therefore in a lower tax bracket, it makes sense to pay the tax now on your income, invest in a Roth, and then enjoy the tax free growth. This is usually the case for people earlier in their career or maybe in a down economic cycle like we are in now. For example, a young worker is making $50,000 and is in a 15% tax bracket. They anticipate growth in their career and earnings, which should hopefully result in a nice sized nest egg for retirement. As a result of their various savings and income sources they may find themselves in a 24% tax bracket in retirement. In this case, it would be smart to be in a Roth, pay the 15% taxes now, and then enjoy tax free distributions that would avoid the 24%. Likewise, the traditional IRA/401k makes more sense when your income is higher. Someone in their peak earning years might be making $350,000 per year which puts them in a 32% tax bracket and upon retirement is anticipating $150,000 of income from various retirement sources which places them in the 22% bracket. In this case, it makes sense to avoid paying the 34% today and, instead pay the 22% in retirement. Finally, a Roth makes sense in general as a future tax rate hedge. While we don’t know what future rates will be we do know that the current tax rates which were introduced in 2016 are set to expire in 2026. Those expiring lower rates combined with a concern that our growing debt will require higher future tax rates might make all current tax rates attractive to what may await us in the future. This wraps up the basics of Roth accounts. I hope this helps explain the basics of the plan to you. If you have questions on whether a Roth is right for you reach out to us at email@example.com. I’ll try to get back on a regular schedule with the blog. Look for the next installment on Roth conversions. 7th St. Financial Inc. (“7th St. Financial”) is a registered investment adviser offering advisory services in the State of Minnesota and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. The presence of this website on the Internet shall not be directly or indirectly interpreted as a solicitation of investment advisory services to persons of another jurisdiction unless otherwise permitted by statute. Follow-up or individualized responses to consumers in a particular state by 7th St. Financial in the rendering of personalized investment advice for compensation shall not be made without our first complying with jurisdiction requirements or pursuant an applicable state exemption. All written content on this site is for information purposes only. Opinions expressed herein are solely those of 7th St. Financial, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation. All investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.
Financial Planning 101 - What You Need To Know About IRAs
Last post we talked about 401k plans. In this edition, we will focus on IRA (Individual Retirement Account) accounts which are the next most popular type of retirement account. There are over 36 million of these accounts in the U.S. according to the IRS containing $9.8 trillion which is nearly one-third of all retirement assets. For the most part, the key attributes of IRA accounts are very similar to 401k plans. I won’t get into the details of explaining again the various terms, for that you can refer to the previous post. There are some differences though and I will highlight both the key similarities and differences here. IRAs are typically funded in one of several ways. It can either be someone’s primary retirement savings account if they don’t have access to one from an employer, as a supplement to their 401k or as a result of a 401k rollover. Key Similarities · Like the 401k, the IRA is a retirement plan where people can contribute pre-tax dollars that grow tax-deferred. · Withdrawals before the age 59 ½ (with a few exceptions) incur a 10% penalty. · RMDs are mandatory starting at age 72. · All withdrawals are considered taxable income. · Both 401k and IRA accounts may have a Roth option. Key Differences · As the title states the IRA is an individual account. This is not an employer sponsored account. These are accounts you can open on your own at a brokerage firm like Schwab, Vanguard or Fidelity or with an advisor through their firm. · The contribution limits for an IRA are much lower than those for an IRA. For 2020 the contribution limit is $6,000 and the catch-up amount is an additional $1,000 compared to the $19,500 and $6,500 for the 401k. · The $6,000 contribution limit is tied to that amount or your earned income whichever is less. · Unlike a 401k there are income limits for being able to make tax deductible contributions to an IRA. For those who are participating in a workplace retirement plan the ability to deduct your contributions phase out between $104,000 and $124,000 for those filing taxes as married joint. The phase-out is 0-$10,000 for those filing married separately. For those individuals who are don’t have access to a workplace plan but are married to someone who does, the phase out is $196,000 - $206,000. If neither spouse has access to a workplace plan then there is no income limit. · Since an IRA is not an employer plan the contributions do not come directly from your paycheck and do not need to be consistent. Contributions can be made periodically or even in one lump sum. · Contributions can be made by April 15th of the following year and still be used a deduction for income tax purposes for the previous year. · For a traditional IRA account there is no employer match since, again, it is an individual account. This combined with the lower contribution limits can make it difficult to accumulate a larger balance as quickly as one can with a 401k. · There are no vesting timetables for IRA accounts. Since all of the contributions came from you all of the funds are yours immediately. · One major upside for an IRA is the amount of investment options that are available. Whereas a 401k has a limited number of mutual funds to select from, an IRA can have an almost unlimited number of investment options. Almost any investment option that is available through your custodian are fair game in an IRA. This includes a choice of thousands of mutual funds, ETFs and individual stocks and bonds. Rollover of 401k to IRA When workers leave their job they have several options on what they can do with their 401k plans. 1. Choose to leave it with your former employer 2. Cash it out – If you select this option be aware that the entire amount will be taxable income to you and if you are under age 59 ½ there will be an additional 10% penalty. 3. Roll it over to an IRA. The best way to do this is via a direct rollover. This is where the funds from your 401k plan are sent directly to your new IRA custodian. This way you avoid the rollover being considered a withdrawal and subject to income taxes and penalties. If the funds are sent to the account holder there is a 60-day window to forward on to the new custodian to avoid taxes and penalties. Otherwise, the entire transfer amount will be considered the same as a cash-out. Changes with SECURE Act Right before the end of 2019 Congress passed and the President signed into law the SECURE Act which contains some rule changes to how these plans are used. Here is a summary of the key updates: · The age cap for contributions was previously 70 and is now unlimited as long as there is earned income · The previous age for beginning to take RMD from the account was 70 ½, it is now 72 That completes our overview of IRA accounts. If you are one of the 36 million IRA account holders in the United States I hope this helps explain the basics of the plan to you. If you have any additional questions you can request a copy of your plan’s SPD (summary plan description) from your employer which will have all of the rules for your specific plan. As always, if you have any questions regarding this topic or anything else with your personal finances please let us know at firstname.lastname@example.org. Look for the next blog post in the coming weeks on Roth accounts. 7th St. Financial Inc. (“7th St. Financial”) is a registered investment adviser offering advisory services in the State of Minnesota and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. The presence of this website on the Internet shall not be directly or indirectly interpreted as a solicitation of investment advisory services to persons of another jurisdiction unless otherwise permitted by statute. Follow-up or individualized responses to consumers in a particular state by 7th St. Financial in the rendering of personalized investment advice for compensation shall not be made without our first complying with jurisdiction requirements or pursuant an applicable state exemption. All written content on this site is for information purposes only. Opinions expressed herein are solely those of 7th St. Financial, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation. All investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.
Financial Planning 101 - What you need to know about 401k plans
Probably the most popular type of investment account in the United States today is the 401k account. According to a 2019 document from the American Benefits Council there are 100 million 401k accounts in the United States holding over $6 trillion. That is almost one account for every two people over the age of 18. What exactly is a 401k account? It is an employer sponsored retirement account that allows you to contribute pre-tax dollars into an investment account. In many cases the employer will contribute funds into the account as well. The funds in the account will continue to grow tax deferred until the funds are withdrawn. At the time of withdrawl the funds are treated as taxable income. Most people are aware of these basic facts so let’s dig a little more into the details of the plan. Contributions As stated above, the employee makes pre-tax contributions into the account. The annual limit for contributions an employee can make in a year is $19,500. If you are age 50 or older you can make catch up contributions up to an additional $6,500 for a total of $26,000. In most 401k plans you can choose to make these contributions as either a percentage of your income or a flat dollar amount. What does pre-tax mean? Pre-tax contributions means that the income you direct into the 401k plan avoids income tax. For example, if you have a salary of $50,000 and you contribute 10%, or $5000, your state and federal income tax is based on the remaining $45,000 of salary. Income used for 401k contributions are still subject to Social Security and Medicare taxes though. Tax deferred growth Different types of investment accounts have different tax treatments. The 401k, as we’ve mentioned is funded with pre-tax income. The other key tax treatment is tax deferred growth. This means that during the time assets are accumulating in the account that individual assets within the account can be bought and sold and there is no tax on the gains realized for any of those transactions. There is no tax due at all until funds are withdrawn. Employer match While the whole tax deferral and pre-tax contribution things are great, the employer match is the truly powerful component of the 401k plan. Depending upon how the plan is structured the employer typically will contribute a certain percentage of your income to the plan depending upon how much you contribute. Typical plans will have rules such as the employer contributing .5% for every 1% you contribute up to 6% or a dollar for dollar match on the first 4% or something to that effect. That is a 50 or 100% immediate return on the amounts you are putting into the plan. That is the best return you will find and contributing at least to the point where you get the full match is considered one of the bigger no brainers in personal finance. Each plan may have slightly different matching rules so refer to your Summary Plan Description (SPD) to get the details on your plan. Vesting Vesting is the concept of obtaining rights to the funds within a 401k over time. Funds that you contribute from your paycheck into the plan are 100% vested immediately as that is your money. Matching funds contributed from the employer are a different story though. Many plans will have a defined schedule, for example 25% each year so that after four years you are fully vested. Again, look to your SPD for the specifics on your plan’s vesting information. Withdrawls Since the 401k is a retirement account there are rules around when and how you can take money out. Withdrawls can begin at age 59 ½ penalty free (there are a few exceptions where you can take penalty free withdrawls earlier). Remember the funds in these accounts have never been taxed so the entire amount you withdraw is considered taxable income for federal and state income tax purposes. And while most of us are aware about the penalty for early withdrawls there is also a provision on the backend dictating when you have to start taking money out of the 401k. Why? Again, the government has never received tax revenue from any of the money in this account and they want to begin getting their share. This concept is known as Required Minimum Distribution (RMD). At the age of 72 you have to begin taking withdrawls from the account based on an IRS life expectancy table. If you are over age 59 ½ you can begin withdrawing funds from a 401k plan penalty free from a previous employers plan. You will have to refer to your SPD about making withdrawls from your current employers plan if over age 59 ½. Investments A typical 401k plan has a limited number of investment options but most will include a fund choice from each of the following categories: domestic stock fund, international stock fund, bond fund, money market fund and target date options. This will allow you to build a basic diversified portfolio at a minimum. Many funds are now setup to automatically enroll people in the appropriate target date fund as a default option. Costs Many people don’t consider the costs involved in a 401k plan but they do exist. Each fund that you invest in within the 401k plan has what’s called an expense ratio. This is shown as a percentage and that percentage is charged based on the amount you have invested in that particular fund. These fees can range from 2% to almost zero. Be aware of funds with high fees. Anything over 1% can be deemed high given the amount of low cost funds that are available. The second cost is the one paid to the company who is managing the 401k plan on behalf of the employer. This should be a very low fee but can vary based on the size of the plan and the level of provider the employer can afford. Similar Plans The 401k is the most popular of these type of workplace plans but there are others that function in the same way. A 403b plan is very similar but is used by people in the education and medical fields. A 457b plan is similar and is used by state and local government employees as well as some medical professionals. Changes with SECURE Act Right before the end of 2019 Congress passed and the President signed into law the SECURE Act which contains some rule changes to how these plans are used. Here is a summary of the key updates: · The cap on the percent an employee can contribute thru automatic annual increases from 10 to 15% · Part time employees that have worked at least 1000 hours or 500 hours for at least three years are now eligible to participate in the plan. · The previous age for beginning to take RMD from the account was 70 ½, it is now 72 That completes our overview of 401k plans. If you are one of the 100 million 401k account holders in the United States I hope this helps explain the basics of the plan to you. If you have any additional questions you can request a copy of your plan’s SPD from your employer which will have all of the rules for your specific plan. As always, if you have any questions regarding your personal finances please let us know at email@example.com. Look for the next blog post in the coming weeks on IRA plans. 7th St. Financial Inc. (“7th St. Financial”) is a registered investment adviser offering advisory services in the State of Minnesota and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. The presence of this website on the Internet shall not be directly or indirectly interpreted as a solicitation of investment advisory services to persons of another jurisdiction unless otherwise permitted by statute. Follow-up or individualized responses to consumers in a particular state by 7th St. Financial in the rendering of personalized investment advice for compensation shall not be made without our first complying with jurisdiction requirements or pursuant an applicable state exemption. All written content on this site is for information purposes only. Opinions expressed herein are solely those of 7th St. Financial, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation. All investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.
In my last installment I started getting into the details of investment vehicles with a focus on stocks. With this installment the focus shifts to bonds and the fixed income category. When constructing a portfolio it is best to have a mix of different asset classes including bonds so it is important to understand what value they provide to your overall investment mix. When an entity needs extra money they have a few options: they can sell stock, borrow money from a bank or sell debt to the public. Bonds are what corporations and governments use to sell debt to the public. Bonds are issued for a specific period of time with a stated interest rate paid to the purchaser. Bonds are usually sold in $1000 face amounts with interest paid semi-annually and then the face amount is repaid when the bond matures. There are three primary types of bonds. The most common are those issued by the U.S. government. These bonds are sold by the government primarily to fund budget deficits. As you see news stories about annual deficits or the mounting government debt this has been funded by the selling of bonds. The government then is responsible for paying the interest to the bondholders. U.S. government bonds are considered the safest investment available because they are backed by the full faith and credit of the government. In theory there is no risk of these bonds not being paid because the government can always print more money. These bonds are available in a variety of term lengths from 1 month to 30 years. The second type of bond is also issued by government entities but instead of the federal government these are issued by state and local governments and are better known as municipal bonds. These are often issued to fund items such as schools, infrastructure or other special projects. The final type of commonly issued bond are those issued by corporations. Companies may issue bonds because they want to raise money but don’t want to dilute equity. Pricing of a bond Bonds can be purchased on an individual basis or a mix of bonds may be purchased together within an ETF or mutual fund. Since mutual funds and ETFs hold a mix of bonds their pricing is completely different than individual bonds. As stated earlier, individual bonds have a face value of $1000 but are rarely sold at this price once issued. The reason for this is because interest rates change over time and that changes the value of the bond. Think about a bond selling for $1000 when it is issued and paying 6% interest. This would provide the bondholder with $60 interest per year. But if interest rates go down to 5% and new bonds are paying $50 per year to the bondholder a bond paying $60 per year becomes more valuable. A bond paying 6% at that point is worth $1200 as at that price a new bondholder would still be receiving a 5% interest payment. On the flip side if the interest rates go up to 7% and a new bondholder would be in line to receive $70 of interest per year from new bond why would they pay $1000 for a bond paying $60 per year? They wouldn’t and the 6% bond would then sell at a discount. To still get a 7% return on the $60 interest the 6% bond would have to sell for about $850. What this shows is that as interest rates go up the price for existing bonds goes down and as interest rates go down the price for existing bonds goes up. This is only a factor if a bond is sold on the secondary market. If you hold a bond until maturity the interest rate fluctuations are irrelevant and you would get your $1000 back. Prices for bond mutual funds or ETFs has nothing to do with the $1000 face value. Instead they package a group of different bonds and sell slices for something that is more reflective of an individual stock price or mutual fund. What determines the interest rate? Like with any investment the rate of return is going to be driven by the risk of that investment. If you hold a bond to maturity the primary risk is that the entity issuing the debt will not be able to repay the principal or make the ongoing interest payments. As stated previously the US Treasury bonds are considered a risk free investment so in turn they have lower interest rates. There are rating agencies like Fitch, Moody’s and Standard & Poor’s who assess the ability of the bond issuer to repay the debt. The higher rating the entity gets the less risk there is determined to be with their ability to make payments which leads to lower interest rates. Entities that are deemed more risky have to pay a higher interest rate to make the investment worthwhile since there is a greater likelihood of them defaulting. This is really no different than an individual having to pay higher interest rates on a loan because they have a lower credit score. Another risk with bonds is interest rate risk. This is the risk that as time goes by interest rates will change and you may be left with an investment that is paying less than current market rates. The longer the maturity of the bond the more risk there is of interest rate changes during the life of the bond and therefore they will tend to pay a higher interest rate. Why hold bonds in your portfolio As discussed in the previous installment, stocks are known for their volatility and historically produce high returns which comes with a higher amount of risk. Bonds historically are a much more conservative investment asset. The returns tend to be much lower but this comes with much less risk. That’s not to say bonds aren’t subject to loss. As noted earlier if interest rates go up sharply an individual bond may lose a lot of its value. But, if like most investors, you are purchasing a bond fund that risk tends to go way down. Over the last ten years the largest bond fund, Vanguard Total Bond Market Index (VBMFX), has lost money in just two of those years and the worst single year performance was -2.26% while the best year has so far been 2019 which has seen a 7.61% gain. Note that over ten years the entire range of returns is right about 10%. On the other hand, the largest stock fund, Vanguard 500 Index (VFIAX), has had its worst year of -4.43% and a best year of 32.33% for a total range of return of 36%. This has been during a historically strong stock market period. In 2008 the VFIAX was down 37% while our bond returned 5.05%. Having bonds in your portfolio provides diversification in your overall holdings. One way to achieve diversification is by having multiple asset classes in your portfolio. This helps smooth things out in your portfolio so if one asset class, say stocks, goes down sharply your entire portfolio isn’t at risk as illustrated in the paragraph above. In addition, bonds produce income. Earlier I mentioned that bonds pay interest twice per year. This interest income can be helpful especially in retirement as it is steady and reliable even if the price of the bond itself is fluctuating. Combining this interest income along with Social Security and dividends from stocks can help inflate your income and help you not have to draw down as much of your retirement assets. When you are younger, this interest can be reinvested to help purchase additional bonds and grow the overall portfolio. Downside of Bonds The main downside to bonds is the smaller rate of return when compared to stocks historically. That said, you shouldn’t be buying bonds with the thought they will give you the best return. Over the long run stocks will provide the best return but in a short term scenario bonds may do better if it is a volatile stock market. One other downside is related to the interest income I mentioned earlier. While it is nice to get the income from bonds, this income is taxed as regular income. Dividends from stocks on the other hand are usually taxed at the same rate as long term capital gains or 15% for most tax payers. Depending on what your income is level bond interest can end up being taxed at a much higher rate. While bonds are generally thought of as being a safer investment than stocks, that really depends on who is issuing the bond. As mentioned earlier, bonds from the US Government are considered risk free but depending on the financial health of a particular company or other government entity there can absolutely be risk that that entity may not be able to pay back the bonds or make the interest payments. Again, bonds are rated so something in the AAA or AA class is very safe. When getting down to the BBB rated bonds you should be aware of the increased risk. This risk should come with a greater interest payout buy but a greater chance the issue could default. How to purchase bonds Very few regular investors go out and purchase individual bonds. Instead most people buy bonds through a mutual fund or ETF. These larger holdings will put together a mix of bonds and you are just buying a small piece of whatever is in the fund. This gives you access to bonds from different issuers, bond durations and interest rates. Examples of the most popular bond funds are Vanguard Total Bond Market (VBMFX), Vanguard Total International Bond Fund (VTABX) and PIMCO Income Fund (PONAX). These and similar bond funds are available in your IRA, 401k plan or your brokerage account. Individual bonds are available via a brokerage such as Vanguard, Fidelity, Schwab or TD Ameritrade. What types of accounts should you use for holding bonds? So you want to go ahead and make bonds a part of your portfolio. Great. But where is the best place to hold them? Bonds can be placed in any of three main types of accounts, 401k/IRA, Roth and taxable brokerage account. That said, in my opinion, bonds make the most sense in a 401k plan or a Traditional IRA. This is because the interest income being generated while the account is growing before retirement isn’t taxed and instead is used to purchase additional bonds. A Roth account on the other hand has its assets grow tax free so it makes sense to put more aggressive assets in that type of account so you can take advantage of tax free growth. In a taxable account, it depends on the type of bond holding. Since interest income is taxed as regular income on bonds in this type of account that is makes holding bonds in a taxable account much less appealing. But, if you hold onto municipal bonds, which are tax free, then they can be a great fit and provide tax free income from a taxable account. Summary Bonds are a great way to add diversification to your portfolio and smooth out some of the risk you take on from the stock market. Just don’t expect the same type of returns you get from stocks and understand this may cause your portfolio to have an overall return of less than “the market” for a given period of time. That’s okay. Remember, you are not always trying to maximize every dollar of return. Instead, your focus should be on having your portfolio do what it needs to do for you and your individual situation. As with other parts of your portfolio look for diversification within your bond holdings by buying bond funds containing different maturities. If you have any questions about how bonds fit into your portfolio please contact a financial advisor. We would love to hear from you at 7th Street Financial. Until next time, I hope you enjoyed the read and learned a little something you can use in your own life. All written content on this site is for information purposes only. Opinions expressed herein are solely those of 7th St. Financial, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation. All investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful. #personalfinance #investments #financialplanning #bonds
Welcome to 7th Street Financials blog on personal finance. In my last installment on investment basics I gave an introduction on investing and now will begin to delve more deeply into individual topics related to investing. The intent of these blogs is to not only provide useful financial advice but also to educate people. The focus for the next several installments will be to cover the individual types of assets that people can invest in such as stocks, bonds, real estate and others. This installment will focus on stocks and what they are and what investing in stocks means. Stocks represent ownership shares of a company or equity. When a company is formed it issues a certain number of shares of stock. The owners of the shares own the company. Companies are either private or public. The vast majority of companies are private, meaning their shares are not available for the public to buy and sell. When a company goes public the shares of stock are made available for buying and selling on one of the stock exchanges I mentioned previously (NYSE and NASDAQ being the primary two). This allows the public to purchase shares of ownership in these companies meaning when you buy a share of Apple you own a very tiny fraction of the company. So why would someone want to buy stocks? Well, the simple reason is that stocks historically offer a very good return on your investment. Now, when I am referring to ‘stocks’ that means in terms of the market like I discussed last installment. Since 1926 the S&P 500 has averaged roughly a 10% annual return. This is a higher annual return than almost any other traditional asset class. 10% rate of return, sign me up! Based on this rate of return why wouldn’t we all just go out and buy stocks? If you recall the principles of investing I went over in the previous installment with this high rate of return comes a higher amount of risk and investing in stocks bring that risk. As you can see in this chart of annual returns for the S&P 500 since its inception the returns are far from a smooth annual 10%. Instead they range from almost a 50% return to a -50% loss which is indicative of the risks of stocks. In the 90+ years of the S&P 500 there has been a negative return in 29 of those years so positive returns outweigh the negative 2 to 1 and in 25 of those years the return has been at least 20%. Again, those are returns of a market or index and not individual stock. Individual stocks are far more risky than the market or an index might be. The ups and downs of individual stocks will be much greater than an overall market which gets smoothed out by the averaging of the ups and downs of the individual stocks. Take for instance just a few of these examples. Take the last 12 years of Chipotle which was a rapidly growing company and then ran into problems with food safety and has since rebounded. The calmest year of the stock was 2012 when it was down 12%. The following year was up 79%, then another 28%, food safety issues hit and the stock went down 30, 21 and 23% in successive years. It has since rebounded with gains of 49% and is up over 70% (going from 428 to 732) so far in 2019. Tesla has had 30 different 20 point moves in its stock price in just the past 12 months. In the past 12 months Facebook started at $196 per share, went to $215, dropped all the way to $127, recovered slightly to $145, dropped to $123, climbed all the way back to $197, dropped again to $164 and is now at $186. Stocks are initially made available through an Initial Public Offering (IPO). An IPO is the sexy glamorous star of the stock trading world. Some IPOs are wildly successful and others not so much. 2019 has seen Beyond Meats (ticker BYND) which was originally priced at $25 per share for its IPO in early May and has since exploded to $200 and is currently at $167 which is an amazing 568% return in just six weeks. On the flipside Lyft (ticker LYFT) which went public in early April at $88 is now at $64. An investment in an individual stock can be the ultimate swing for the fence move depending on the type of stock you buy. Market Capitalization Stocks can be classified in multiple ways. One of which is how big the company is, also known as market capitalization. Market Capitalization is calculated by taking the number of issued shares multiplied by the current share price. Large Cap companies are those with a market cap greater than $10 billion, mid-cap companies are valued between $2 -10 billion while small cap companies are less than $2 billion. The larger the company the less risky it tends to be. The reason for this is by the time a company reaches this stage it is thought it is less likely to experience big swings either for the good or bad. That doesn’t mean large cap stocks can’t have big moves in their stock price as evidenced by the examples above though. Mid-cap stocks are thought to be less risky than small cap stocks as well. Value vs Growth Another way stocks can be categorized is as value or growth. Value and growth companies can be found at all market cap levels. A growth stock is one that, well, is experiencing rapid growth in their sales and/or income. These companies tend to be newer or in a rapidly growing industry or technology area. Current examples include Amazon, Facebook and Google. Value stocks on the other hand tend to be more stable in their growth, older and in more established industries. Current examples include Johnson & Johnson, Exxon Mobil and Proctor & Gamble. These companies are less likely to see the big swings in their stock price but that stability may be very attractive to certain investors. Also, value stocks are more likely to pay a dividend back to their shareholders. A dividend is when the company sends back a portion of their profits. This can make the stock more attractive to potential buyers since the returns may not be as a high as those for growth stocks. Growth stocks are less likely to pay a dividend as they tend to reinvest all of their profits to grow the business. Valuing a stock How do you know if a stock is a good deal? The short answer is you really don’t. By its definition the price of a stock should reflect the future cash flows the investor can expect to receive in the form of dividends and/or rate of return on stock price. The truth is that it is much messier than that. Stock prices are really driven by the collective mindset of buyers on where they think the stock price is headed. What makes it messy is that people reach different conclusions about the same stock and arrive at those conclusions at different times so while one person may think the stock has peaked another may think it has a long way to go yet. That being said, there are multiple things that people look at to help them determine where they think a given stock price will go. One is to look at the fundamentals of the company. This involves looking at the company’s financial statements to see how healthy a company is. The overly simplistic logic is that a healthier company can support a higher stock price and if the future outlook is good then the stock price can reasonably be determined to increase as well. Factors that people will look for are sales growth, profit growth and keeping expenses and debt in line. If sales and profits are increasing that is a good sign and if people buy into that growth the price will go up. People may also look at the fundamentals of an industry or the entire economy as well. For instance even if a company’s financials look positive if that company’s industry is in a downturn the expectation may be made that eventually that company will suffer as well which may drive more people to sell the stock driving down the price as a result. There are a number of ratios people will look at as well. One of the most popular of these are Earning Per Share (EPS). This measures the stock price divided by the number of shares or, in other words, how much of the company’s profit is yours if you own the stock. Generally the higher the number the better the outlook for the company. Another very popular ratio is the Price/Earnings Ratio (PE) which measure the stock price divided by the EPS. In other words how much are you paying for a dollar of that shares profit. As a general rule the S&P trades at about a 16-17 PE ratio meaning you are paying $16 per dollar of profit associated with that share of stock. The conventional thought is when the PE ratio is higher than this level the stocks are priced too high given the profit they are generating which would be an indication prices are due to fall. Likewise, if the current PE is at 14 that might be an indication the stock prices are too cheap. But, individual companies will have wildly different PE ratios and doesn’t necessarily mean the price is too high or low as much of that is speculation around where the company can go. For instance, a relatively new company that is growing may have a very high PE ratio because people are buying into the growth and future expected profits even though current profits may be very small or possibly negative. A current example is Pinterest (ticker symbol PINS) which has a PE ratio of 1345 which is very high due to very small expected profits but reported sales growth of 57% over last year which is phenomenal growth. Time will tell if this company can continue to grow and with increased sales achieve the right amount of profitability to support a higher stock price. Publicly traded companies will issue guidance on where they think the company’s financial future is headed. Analysts who work for financial firms follow these companies and will also come up with their own predictions on sales and profitability numbers. These predictions become a target and each quarter when the company releases their financial results the actual results are compared to the targets and future guidance. If actual results outperform the targets and guidance says this should continue this indicates the company is performing better than anticipated and a bump in stock price may follow. The reverse happens when estimates miss target or guidance is lowered. Another method people will use to determine where a stock price is headed is to perform a technical analysis of the stock price and the trading of that stock. This method doesn’t really look at how the company is actually performing at all but instead looks at the historical trading of the stock to predict the future. For instance, as companies bounce around with their prices a trend may develop for a given stock that it tends to get to $100/share and then drops again creating a ceiling of support. If the stock were to ever crack the $100 barrier that would be a sign to buy as something has changed and the stock has established a new higher ceiling. These types of evaluations can be done to predict also when a stock price will head lower. Another factor in technical analysis is looking at the volume of stock traded in an up or down move of the price. For instance if the stock heads lower on light trading there might not be much to read into it but if it goes lower on heavy trading that might be an indication that something has truly changed with the outlook of the stock and could indicate a further dive in price. How to buy a stock So now whether you have done your research or not you have decided to buy shares of a given stock. How do you actually do it? You can work with a number of different professionals such as a stock broker, investment manager or financial planner or try it yourself. If you work with a professional it will require establishing a relationship with them and opening an account that they would oversee. These professionals will probably be the ones recommending the stock picks to you but they will execute the trade on your behalf. In exchange for doing this they will charge you a fee. A broker will likely charge a commission while an investment manager and financial planner will charge you a fee based on the relationship you have and not so much for any specific transaction they perform for you. Now, let’s say you want to go on your own. To do this you will need to open an account at a brokerage firm like Fidelity, Vanguard, Charles Schwab or TD Ameritrade which are the largest (in fair disclosure, I use TD Ameritrade as my custodian for investments). Each stock has its own symbol used for trading like the ones I mentioned previously in this article. When purchasing a stock you will be presented with several options like this example for purchasing Apple (ticker symbol AAPL): You will be asked to provide the number of shares you wish to purchase and an order type. A market order will process the order at whatever the current price, a limit order will allow you to enter a price and once the market price is at or below that price it will trigger the transaction. You will also have options for how long the order stays in place. This is only an issue for a limit order as it might take time for the order conditions to be met. You can select the order to expire at the end of the day or in after-hours trading as these platforms will let you buy and sell stocks 24 hours a day. You have probably seen the ads on tv for these forms touting their services and their low prices. When they refer to $4.95 to $6.95 that is the price they will charge you for executing the transaction on the stock. For example, if you purchase $1000 shares of a stock and the fee is $4.95, you will actually end up buying $995.05 of the stock with the rest having gone to pay the fee. The fee is the same regardless of the amount of the stock you buy or sell. I will quickly mention there can be multiple classes of stock issued by a company. By far the most common type is type A common shares which are the shares that are traded on open market most frequently and have voting rights. Companies may issue class B stock as well that have lesser voting rights. Companies may also issue preferred stock which may not have the price fluctuations but tends to get paid a dividend and will get paid out before the common shares. By buying a stock that you intend to hold in hopes the stock price will go up and/or receive income via dividends you are going ‘long’ on the stock. This is by far the most common way to get into stocks and will be the only method I cover here. You can also short a stock, buy or sell options, or trade on margin. These are all a little more in depth and not really for investing 101. Taxes Now that you own a stock how do you get taxed? There are two ways to get taxed when you own stocks. The first is when you sell stocks. When you sell a stock you will generate a capital gain or loss depending on if the stock is worth more or less than when you purchased it. If you sell the stock after owning it less than one year than it will be considered a short term gain or loss and is treated just like ordinary income and taxed just like your wages. If the stock has been held for more than one year than the gain or loss is considered long term. This is important because long term capital gains are taxed at lower rates, usually 15%, depending upon your income. If you sell multiple stocks during the year the gains and losses are netted against each other to determine if you have a gain or loss and whether it is short or long term or both. The second way to be taxed with stocks is through receiving dividends. Not all stocks pay dividends but if you own one that does and you have held the stock for more than 60 days before the dividend was declared it will be considered a qualified dividend which will be taxed much like long term capital gains, usually 15%, depending on income. Unqualified dividends will be treated as ordinary income and taxed like your wages. Conclusion Stocks are risky but have a high historical rate of return. When investing long term it is hard to generate the returns needed without a portion of your portfolio dedicated to stocks. Stocks help provide a hedge against inflation due to the higher return. Investing in the market is one thing but picking individual stocks can be especially risky. This should provide a solid introduction to stocks for you which will carry through on future installments. The next installment will cover bonds. As always, if you have any questions about this topic or any other personal finance issues reach out to 7th Street Financial at or visit the website at www.7thstfinancial.com. Disclosure – Jeff Burke personally owns shares of Facebook, Apple and Pinterest in his own portfolio. 7th St. Financial Inc. (“7th St. Financial”) is a registered investment adviser offering advisory services in the State of Minnesota and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. The presence of this website on the Internet shall not be directly or indirectly interpreted as a solicitation of investment advisory services to persons of another jurisdiction unless otherwise permitted by statute. Follow-up or individualized responses to consumers in a particular state by 7th St. Financial in the rendering of personalized investment advice for compensation shall not be made without our first complying with jurisdiction requirements or pursuant an applicable state exemption. All written content on this site is for information purposes only. Opinions expressed herein are solely those of 7th St. Financial, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation. All investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful. #investing #stocks #personalfinance #financialplanning
In this latest installment of my Financial Planning 101 series I am moving onto the topic of investing. The last installment found here wrapped up my coverage of insurance and it is time to move into a new area. I am guessing more people will find this more interesting but I started with those other topics for a reason as I believe the previous topics dealt with the issues that form the foundation for solid personal finances. Covering investing will take some time so there will be a number of individual postings on this larger topic. This post will act as an introduction to investing. Later posts will get into more specific topics. Let’s establish some basic terminology that will come in handy to understand this and future installments. Stock Market: People will generally refer to the “Stock Market” but what does that really mean? The definition of stock market doesn’t really match up with what most people mean when they mention the ‘market’. The stock market is an established exchange where stocks of individual companies are listed for buying and selling. We have two primary stock markets in this country, the New York Stock Exchange (NYSE) and NASDAQ. NYSE is considered the leading stock exchange in the world with 2,800 companies listed and over 1.4 billion shares traded daily on average. NASDAQ tends to have more tech centered focus with 3,300 companies and 1.8 billion shares traded per day. Stock Index: A stock index is a group of stocks that have their collective performance measured. These stock indexes are what most people are actually referring to when they talk about the stock market. There are dozens of indexes used between the stock markets in the U.S. but there are three primary ones we follow. Dow Jones – This is the granddaddy of all indexes and the one that gets the most coverage on the news. We are all familiar with hearing The Dow was up or down in a given day. The Dow Jones is actually comprised of just 30 stocks that are selected to represent a cross section of the America economy. The Dow is a price weighted index meaning that a company like McDonalds which is trading at $200 per share has four times the impact on the Dow that Coca-Cola has which is trading at $51 per share. Because of this companies with high share prices such as Google and Amazon while amongst the largest companies in America are not part of the Dow. S&P 500 – This is a collection of 500 of the largest US companies. This index is maybe the best barometer for the overall market given the breadth of companies and industries represented. This index is market cap weighted meaning that a company like Apple which is worth near $1 Trillion will have 200 times the impact on the index than Nordstrom which has a market cap of just over $5 Billion. As a result this index largely influenced by Microsoft, Apple, Amazon, Facebook, JP Morgan Chase and Google. NASDAQ – This index spans the entire 3300 companies listed on the NASDAQ market. This is also a market cap weighted index and since this is a tech heavy index it is most influenced by Microsoft, Apple, Amazon, Google, Facebook, Intel, Cisco, and Netflix. Portfolio: This is the collection of your investments. This includes everything in all of your investment accounts, including retirement accounts and other types of investment accounts. Now that we have established some of the basic terminology let’s go over some of the basic principles of investing: Risk vs. Reward This is the name of the game when it comes to investing. The more risk you are willing to take on with investing the greater the returns you should expect over the long run. Stocks are considered a more risky investment but over the long run has averaged a 10% return (S&P 500 average return from 1926 to 2018) compared to bonds which had an average return of 5.4% over the same timeframe. The risk of course is in the short run. The stock market is more vulnerable to a sharp downturn than bonds which are viewed as more stable. And we don’t really know when that downturn might happen. TV is full of talking heads who may claim they do and there is some statistical evidence that is available that might be a gauge on what could happen but it does not always play out that way. We recently have come through one of the more volatile times in market history. In 2008 the S&P 500 was down 38.5% and is up roughly 400% in the years since. So while overall the returns since the beginning of 2008 have averaged 6.5% there were very nervous times for many investors for a period of time. 2. Invest early, invest often. We have all seen the charts that show the impact of investing over a number of years. I will include one here as well just to hammer home this point. The most powerful tool you have as an investor is compounding interest. The longer your money stays invested and can continue to grow the better. This chart illustrates that point. The person who began investing at age 25 has a slow build of their nest egg. But once they hit roughly age 50 the portfolio begins to grow much more quickly. Let’s assume an 8% rate of return. Once they have accumulated $400,000 the 8% return starts to really add up. That alone is worth 32,000 plus the 5000 they invested. That brings the total to 437,000. Another 8% return on top of that is 35,000 plus the 5000 that was invested is 40000 of growth for new balance of 477,000 and the growth continues to accelerate from there. On the flipside, the person who didn’t begin investing until age 35 never really gets a chance for those big gains because by the time they would start to happen they are at retirement age and now need that money for expenses. So the lesson is for those of you who are young and feeling like money is tight and you feel like you need to wait until you are making more money please try to find a way to start saving right away. There will always be some expense that comes up that will make it seem like it isn’t the time to start investing so do it now and just get used to that money not being there. You will thank yourself in the future. 3. Market timing is extremely difficult. We all know the goal of buying high and selling low. The problem many investors run into is that they get hung up on selling at the absolute peak price or trying to buy at the lowest price possible. These exact price points are impossible to know. You will be much better off in the long run if you decide it is time to buy or sell and just moving forward with it. Again, none of us knows if from one day to the next the market will be up 300 or down 150. And, in the case of mutual funds, the price isn’t determined until the end of the day anyway. Here is another chart showing the potential impact of getting too cute with the market and waiting to buy. This shows the impact on your performance of you missed out on the top five days over the past 20 years. As you can see it would make almost a 35% difference in the overall return on your investment. Bottom line: if you are comfortable with the return you have made go ahead and sell. If you feel that an investment is a good value at the current price, go ahead and buy it and don’t worry about the couple of bucks wither way that could have been made. The other piece of advice that goes along with this is to simply stay invested. Many people get nervous when the market gets volatile and want to sit on the sidelines until things get better. The problem is by the time they feel better about the market the gains might have already been largely realized and they are buying back in at the top of the market. I recently spoke to someone who mentioned they pulled everything out in 2009 after the financial crisis and still hadn’t reinvested yet. They mentioned they avoided losing everything. I didn’t have the heart to tell this person they also missed out on the roughly 400% appreciation that has taken place since then. 4. Most gains are a result of a diversified portfolio. I’ll speak to diversification more in depth in a later installment but basically diversification is the principal of spreading your investments around between a variety of asset classes and individual assets. This is a key tool in the risk management of your investments. At the same time it is beneficial to your overall returns. The ‘market’ has many segmentations to it and at any given time some of these segments will be performing better than others. By being diversified you are protected against the risk of being too heavily invested in the poorly performing segment or individual asset and you will also be invested in whatever segment is performing well at the time. Admittedly, this is the glass half full take on this because at the same time one can use the rebuttal that you’re missing out on returns by not being in the hot segment. While this may be true, the fact is it is hard to know what the hot sector is until after it has made its run. A down sector might have a couple of good weeks quietly when most people aren't watching. Many might think of tech as the hot segment and while overall for the last few years that has been the case there have been windows of time where others have been better performers. As of June 4, 2019 the top sector of the year has been Utilities which has been up 17.4% over the past year while Tech is up just 2.35%. Over the past three months Real Estate is the leading sector up 4.82% compared to 2.23% for Tech. Over the past month Utilities have been the leader up .49% while Tech is down 7.71%. As you can see over the past month Utilities have outperformed Tech by over 8%. Now, I would challenge you to find a person who 30 days ago was so smart that they moved their investment portfolio out of Tech and went all in on Utilities. Anyone want to raise their hand who did that? Anyone, anyone? No, I didn’t think so. The reason for this was a couple of bad days killed Tech, and Utilities, which are less volatile, basically treaded water. By being diversified though you would have had a portion of your investments in Utilities which would have helped offset the beating Tech took. 5. Rebalance your portfolio periodically. When you put together your diversified portfolio you will most likely have a target percentage for each of those assets in your overall portfolio. You will also find that individual assets will grow at different rates and this leads to individual holdings ending up in different percentages from your target. For instance, say you have Mutual Funds A and B and want each to be 20% of your portfolio. Over a period of time fund A performs well and now makes up 23% of your portfolio while fund B didn’t do as well and now sits at 18% of your portfolio. In this case rebalancing would call for selling a portion of fund A to get back to 20% and then buy more of fund B to get that back to 20% as well. Most guidelines will call for you to do this exercise once or twice per year. This practice will also reinforce the concept of dollar cost averaging which will be discussed more later as well as locking in the practice of selling high and buying low. 6. Expenses can erode your returns. I will devote more time to this issue in a future post but for the purpose of this installment I want to point out that expenses can be a real drag on your returns. Individual investments may have a load fee or management expense fee associated with them, There might be a fee tied to your investment account and finally, if you have an advisor they might be charging you a fee based on your investments. These fees can really add up over time. That concludes this primer on investing. Hopefully you found something interesting or valuable here. The next installment will focus on stocks and their characteristics. As always, if you have questions about your own personal finances I would be happy to talk to you, Send an email to or schedule a 30 minute meeting here. #personalfinances #money #financialplanning #investments #investing