Discovering Investment Vehicles

In the investment world, there are many different types of investment vehicles in which to place your money. Which vehicle you choose depends on your goals. It depends on your time range, your objective, your risk tolerance, and the rate of return you are attempting to achieve.

This chapter will explain many investment vehicles that you may have in your investment portfolio. 

 Checking Accounts

Checking accounts are best used as your everyday type of account. You can deposit payroll checks and other income and then pay your expenditures. This account is like a revolving door with money coming in and going out rapidly. It has a quick cash flow. It is generally best to keep approximately two months’ of expenses in this account so it can handle the cash flow and emergencies.

Be sure to shop around at banks, savings and loans, and credit unions for the best service and lowest rates. Focus on avoiding the monthly service charge as this can add up quickly over several years. Shop for other fees such as low balance charges, ATM fees, check charges, and other fees.

Don’t buy your checks from your bank; instead buy them from one of the many mail order check-printing companies available in newspapers and magazines.

Look for an account that offers interest with checking. If the fees are low enough, it can add a small amount to your account.

Savings Accounts

Savings accounts are found at banks, savings and loans, and credit unions. You receive interest for placing your money in an account there. The interest rate however is usually quite small, under 5% per year.

Bank savings accounts are backed by the Federal Deposit Insurance Corporation (FDIC) insurance. Many people, usually older ones, clamor after savings accounts because of the insurance, remembering back to the days of bank failures. They generally have no risk tolerance and don’t realize or care that they are receiving a much lower interest rate for the insurance.

The 1980s highlighted how poorly much of the savings and loan industry was run and showed that banks are not perfectly safe, either. The FDIC insurance system is just an insurance system. If there were ever such an economic disaster in the U.S. that money in savings accounts declined in value, the whole U.S. banking system could be in jeopardy and the FDIC insurance system could collapse. 

Bank CDs

This investment vehicle is an extended type of savings accounts. A bank CD (certificate of deposit) is an interest-bearing bank investment that locks you in for a specific period of time. Generally the bank offers certificates from 6 months to 5 years. This locked-in time range allows the bank to pay you a higher interest rate than a standard savings account. If you need to withdraw funds from the CD prior to maturity, the bank will charge you a penalty for early withdrawal. Like savings accounts, bank CDs are also backed by FDIC.

There are two primary considerations in planning for your investment in a CD:

1) Term: The most popular type of CD is the 6-month certificate, but CDs are available with maturities ranging from 7 days to 15 years. During the term of your CD, the money you’ve invested is relatively costly to liquidate. If an emergency arises which requires you to withdraw your money before maturity, you’ll be penalized for it. This penalty is known as early withdrawal penalty and will vary from bank to bank. Thus you’ll want to consider carefully when you’re likely to need the money before you invest in a CD.

2) Rate of Return: The interest paid on a CD will vary not only according to the term of the certificate but, from time to time, as interest rates fluctuate, as well as from bank to bank. Don’t buy your CD at the first bank you visit. Check the Internet for rates, contact your investment advisor for the highest rates available. Ask about how the bank credits the interest earned to your account. The more frequently interest is credited, the better for you, since each time your account grows through an interest payment, the amount of money you have working for you grows as well.

Who Should Purchase CDs?

Generally, certificates of deposits should not be in an investment portfolio because there are so many alternatives. Millions of people own them because of their safety, convenience, and confidence in their bank, yet investors lose because they deny the chance for higher yields, which come with accepting more risk. However, there are certain times when CDs do make sense.

1) Emergency savings: We recommend an emergency fund equal to at least three months of expenses. A short-term CD (three months or less) can be a good choice for emergency savings since the funds are relatively liquid.

2) Short-term goals: Savings for a car, house or any other item in the next one to two years can make a good justification for CDs.

3) The parking lot theory: An inheritance, lottery, or any windfall may give you a large sum of money. However, you may need a little time to decide where to invest. CDs make a fine short-term parking lot for those funds. 

Treasuries

The U.S. Treasury Department provides for the enormous financial needs of the federal government. Much of the money the Treasury raises comes from the sale of securities to the general public. These securities are known as Treasury obligations and consist of Treasury bills, notes, and bonds.

Conservative investors often invest in Treasuries because they are safe and secure and are a good alternative to bank CDs. In comparison with similar obligations issued by corporations, Treasury obligations usually pay a yield, which is one or two percentage points lower. However, many people are willing to accept the slightly lower yield in exchange for absolute safety.

Treasury Bills

Treasury Bills (T-Bills) are short-term federal debt, sold in denominations of $10,000, with $5,000 increments thereafter. T-Bills are issued in original maturities of 13, 26, and 52 weeks. The first two are auctioned weekly, while the 52-week bill is auctioned every 28 days. They can be purchased through brokers or directly from the Federal Reserve. They are issued on a discount basis under competitive bidding, with the face amount payable at maturity. The investment return on bills is the difference between the cost and the face amount. Bills may be sold prior to maturity at a competitive market rate, which can result in a yield greater or less than the original acquisition rate. T-Bills are an extremely safe type of investment vehicle.

Treasury Notes

Treasury Notes are similar to T-Bills except they mature in one to ten years and are sold in denominations of $1,000 to $100,000. Treasury notes, like T-bills, pay interest rates determined by auction. However, they are not sold at a discount. Instead, they pay interest every 6 months at a rate fixed at the time of purchase. In this respect, they resemble corporate bonds. Treasury notes can be bought and sold on the secondary market.

Treasury Bonds

Treasury Bonds are similar to T-Bills and Notes except they mature in five years or more and sell in denominations of $1,000 to $1,000,000.  

U.S. Savings Bonds

These bonds are issued by the U.S. Treasury and are designed for the conservative investor. Presently, they pay a flexible interest rate based upon 85 percent of yields on five-year government treasury securities. The rates change each May and November. 

If you hold the bond for five years, you will receive the average of all the rates in effect while you owned the bonds, but they pay a fixed rate if cashed before five years. You can buy a $50 bond for $25 or a $10,000 bond for $5,000. The maximum amount of bonds a person can purchase during one year is $15,000 ($30,000 face value).

The most common U.S. savings bond is the Series EE, which the United States Treasury began issuing on January 2, 1980, to replace the series E bond. Series EE bonds also have a guaranteed minimum yield if the bonds are held for five years. Call your local bank for current minimum yield. Presently, U.S. savings bonds are exempt from state and local taxes, and federal tax is deferred until the year cashed. As of January 2, 1990, Series EE bonds that are used for higher education are exempt from federal tax. Note: They must be bought in the parent’s name, not the child’s.

U.S. savings bonds Series HH are sold at face value, with $500 being the minimum investment. The bonds mature in ten years. The interest is paid every year; therefore, when the bond matures you have already received your interest. Interest is taxed each year.

Money Markets

A money market account is offered by mutual fund companies and brokerages. They are like a mutual fund that invests in short-term issues such as Treasury Bills, bankers notes, and corporate commercial paper, which is issued by the largest and most credit-worthy companies and U.S. government securities.

There are hundreds of money market funds that invest billions of dollars. Money market funds are closely regulated by the U.S. Securities and Exchange Commission. Money market funds’ investments can exist only in the most credit-worthy securities and must have an average maturity of less than 120 days. Money market funds maintain a constant $1-per-share price.   

Even though this vehicle is NOT insured by FDIC, it is considered to be a safe investment, and to date no major money market fund has lost investors’ principal investments. If the lack of insurance on money market funds still spooks you, consider a fund that invests exclusively in U.S. government securities. These money markets are virtually risk-free because they are backed by the full strength and credit of the federal government. These types of accounts typically pay a lower interest rate, usually ¼ percent less (even though the interest is state tax free).

Municipal Bonds

When a city, state, or county needs funds to build schools, roads, or water and sewer facilities, they offer bonds. Because municipal (muni) bonds are tax-free, the interest rates offered are lower than regular bonds of similar type. Tax-exempt municipal bonds yield about 85 percent of compatible taxable instruments; the investor in the 28 to 39.6 percent tax bracket has a chance to lock in excellent returns.

Municipal bonds that offer higher interest rates than what is presently being offered are most likely to be called in, because the issuer will want to redeem them with new ones paying lower yields. When a bond is callable, it may be redeemed by the issuing agency prior to the maturity date, usually within 10 years after issue, and usually at a premium. Of course, this places a lid on potential profits, which may be a significant loss to you if interest rates decline greatly after the bond is issued.

As with any investment, risk is a factor to consider in purchasing municipal bonds. Like corporate bonds, municipal bonds are rated by two major independent rating services: Moody’s and Standard & Poors. The AAA rating is the highest; the C rating is the lowest. In general, the lower the rating, the higher the yield. However, we don’t recommend that you purchase bonds with a rating lower than A, since the slightly higher interest rate you may be offered on the lower-rated bond isn’t worth the sacrifice in safety. Also, when financial times are uncertain, investors will look for high-quality bonds even though they do produce a lower yield.

A technique when investing in municipal bonds is known as laddering. What is done is that you purchase bonds maturing in different years. Therefore, if rates have risen when a bond matures, you will be able to reinvest the proceeds into an instrument paying the new high yield. Conversely, if interest rates should fall, a portion of your holdings will still earn interest at the higher rates.

When a municipality issues muni bonds, the city’s or state’s credit is on the line. If bonds are somewhat lower-rated, the municipality must pay higher-than-normal interest on the issued bonds. To save money, it may purchase insurance that guarantees that all payments of principal and interest will be made on time. Thus it may appear that the insurance is free to the investor, but that is not true. Since the insurance raises the quality of the municipality’s credit, the yield on the bond issued will be lower. Because the cost/yield difference between an insured and an uninsured bond is narrow, the insurance has become a “good buy.”

Municipal Bond Funds

A municipal bond fund is similar to a money market fund: its shares are highly liquid. Each fund sells or redeems shares at its net asset value (NAV) at any time. The managers of a municipal bond fund are constantly trading. Thus the fund as a whole never matures but goes on indefinitely buying and selling bonds to take advantage of changes in the marketplace.

One advantage that municipal bond funds have is that buyers can invest a much smaller amount of money than they would need to buy a municipal bond on their own. Most municipal bond funds require an initial investment of at least $1,000. Any time thereafter you can buy additional shares in the fund. You have the option of receiving a check for your monthly earnings or having them automatically reinvested to purchase additional shares in the fund. Whenever you wish, you can sell your shares back to the fund. However, since the value of the bonds in the fund’s portfolio fluctuates over time, you may or may not get back your original investment when you sell your shares.

Bonds

Bonds are a type of loaner-ship. This is where you invest (loan) some money and that organization pays you back interest for using the money. In a way you are a bank. The types of organizations that may sell bonds are corporations, local, state, and federal government, foreign governments, and other entities.

When investing in bonds, you should be aware of some of the terms. Principal is what you originally invest. The maturity date is the date on which the loan must be paid in full; it can range from one day to thirty years. If it is less than one year, it is called short-term debt, if it matures within a few years then it is called intermediate bonds, and if longer than ten years, it is called long-term debt. Interest is the money you receive in return for loaning your money.

There are three types of risk involved in bonds: (1) the interest will not be paid; (2) the principal will not be returned; (3) the market value of the bond might decline due to rising interest rates, making your investment worthless. For example, if you’re holding a bond issued at eight percent, and rates increase to ten percent, your bond decreases in value. Because why would anyone want to buy your bond at the price you paid if it yields just eight percent and they can get ten percent elsewhere?

Unless the Federal Government defaults, there is “no risk” when you loan money to the government. So government securities are the safest of all debt instruments available. However, government securities, like other bonds, can lose market value if interest rates rise.

Corporate bonds can be purchased the same way as stocks—through a brokerage firm. Government bonds can be purchased from commercial banks or a Federal Reserve branch bank. Corporate bonds have more risk than government bonds due to the fact that corporations are less stable than the U. S. Government.

High-yield bonds, also known as Junk Bonds, are speculative bonds that have a poor rating. These bonds pay a higher interest rate but are a higher risk. Generally bonds with a B or lower rating are classified as high-yield bonds. 

Mortgage-Backed Securities

Mortgage-backed securities are investments in a portfolio of home mortgages and are sometimes referred to as "pass-through" securities because homeowners’ mortgage principal and interest payments are "passed through" to investors.

The most well-known mortgage-backed security is the Ginnie Mae, which is issued by the Government National Mortgage Association (GNMA). Ginnie Maes carry the "full faith and credit" guarantee of the Federal Government and generally pay a slightly higher rate than Treasury bonds.  Ginnie Maes require a $25,000 minimum purchase, with $5,000 increments, from brokers, but can also be purchased indirectly for $1,000 through units in a Ginnie Mae unit investment trust. They can also be purchased through mutual funds that invest in U.S. government agency securities (minimum amounts vary per fund).

Two other mortgage-backed securities that are not backed by the federal government are Freddie Macs, issued by the Federal Home Loan Mortgage Corporation (FHLMC) and Fannie Maes, issued by the Federal National Mortgage Association (FNMA). They also require $25,000 and typically pay a higher rate than Ginnie Maes to compensate investors for the extra risk of not being government-insured.

The biggest disadvantages of all three mortgage-backed securities are an uncertain maturity and irregular monthly payments. Although the mortgages in their portfolios are issued for 30 years, the average life of a mortgage-backed security is only 10 to 12 years because homeowners frequently move or refinance. Also, if investors spend the part of their monthly check that is a return of principal, instead of reinvesting it, they will have nothing left when the last mortgage in their Ginnie Mae portfolio is repaid.

Collateralized Mortgage Obligations

Collateralized mortgage obligations (CMOs) are another type of mortgage-backed security. CMOs were developed to address investors’ concern about receiving income from other mortgage-backed securities in unpredictable increments.

With CMOs, the portfolio of mortgages is divided into various classes, called tranches, thus offering investors a choice of estimated maturity dates to match financial goals. Investors in a particular tranche typically receive semi-annual interest payments that differ from period to period and from other tranches. Tranches with a longer maturity generally pay a higher return to compensate investors for incurring greater interest rate risk. The principal portion of mortgage payments corresponding to all tranches goes to investors in a single tranche until that tranche is retired. Each tranche gets its principal back when all the tranches before it have been repaid. CMOs are available in $1,000 increments through brokerage firms and pay a higher yield than comparable mortgage-backed securities.

The two disadvantages of CMOs are their complexity and the fact that principal prepayment can still come sooner (or later) than expected. Just as with other mortgage-backed securities, investors must realize that principal is being repaid throughout the life of a CMO, not at maturity like bonds. Investors who mistakenly think that CMO payments are just interest may inadvertently spend their principal.

Zero-Coupon Bonds

Zero coupon bonds (zeros) are issued at a deep discount but don’t pay interest until they mature. Zeros are usually sold in denominations of $1,000 per bond, at prices far below par value. During the term of the bond you receive no interest—hence the term zero coupon—since coupon means interest in bond terminology.

When the bond matures, you are paid face value, including the interest that’s accumulated over the term of the bond. For example, you may purchase a $20,000 zero-coupon bond with a six-year term for $13,500. At the end of the six years, you will receive $20,000.

One advantage of zeros is that you can invest relatively small amounts up front and choose maturity dates to coincide with times you know you’ll need the money—for example, college tuition.

One drawback to zeros, however, is that taxes are due annually on the interest that accrues, even though you don’t receive the actual payment until the bond matures. Another drawback is that zero-coupon bonds are very volatile in the secondary market, so if you have to sell them before maturity, you might have to sell at a loss.  

Convertible Bonds

As their name suggests, convertible bonds are a type of corporate bond that allows investors to "have their cake and eat it too," almost. They provide the upside potential of stocks (the opportunity to participate in company earnings) with the downside protection of bonds (a fixed return and repayment of principal at maturity).

Convertible bonds can be exchanged for a specified number of shares of common stock of the issuing company. As the price of the company stock increases, the convertible bond price also increases because the option to convert becomes more valuable. This correlation is true whether an investor chooses to convert or not. The trade-off is that convertible bonds generally convert to fewer shares of stock than you could buy for the cost of a bond. Almost all convertible bonds are callable.

Even though they are a "hybrid" investment, convertibles, like all bonds, are sensitive to interest rate fluctuations. They can be purchased as individual securities in $1,000 increments or through convertible bond mutual funds.

Preferred Stock

Although technically a form of stock, preferred stock is often listed as a fixed-income investment because it behaves more like a bond, but has no fixed maturity date. The word "preferred" refers to the fact that shareholders receive preferential treatment. They are paid dividends before common stock shareholders and, in the event of a corporate liquidation, can claim corporate assets after bondholders but before common stock shareholders.

Preferred stock typically pays a fixed dividend rate similar to the coupon rate on a bond. Share prices fluctuate inversely with changes in interest rates. Par value on preferred stock is usually about $25 per share so a round lot (100 shares) would cost $2,500. Dividends paid are a fixed percentage of par value.  Preferred stock shares are available through brokerage firms.

Common Stock

All corporations have common stock. If you organized a corporation for the purpose of manufacturing widgets, and sold one share of common stock to each of nine people at $100 per share and one share to yourself At $100, the corporation would be capitalized at $1,000 and would have ten stockholders. In buying one of these shares, you became a shareholder or part owner of the corporation. You took an equity position and will participate in the future gains, or lack of gains, of the corporation for as long as you hold your share.  

Stocks are the most common investment traded on securities markets. Companies that issue stock are from every industry and sector including: airlines, computer manufacturers, department stores, oil drillers, restaurants, and many others. You can buy stock in more than 9,000 publicly-traded companies, though chances are your portfolio will only have a tiny fraction of what’s available.

Since shareholders are part owners of the corporation, if the company does well, you may receive part of its profits as dividends and see the price of your stock increase. But if the company fares badly, the value of your investment can drop, sometimes substantially.

A stock has no absolute value. At any given time, its value depends on whether the shareholders want to hold it or sell it and on what other investors are willing to pay for it. If the stock is hot and lots of people want lots of shares, the value will go up. If a company is losing money, the stock value will probably drop. Some stocks are undervalued, which means they sell for less than analysts think they’re worth, while others are overvalued.

Investors’ attitudes are determined by several factors: whether or not they expect to make money with the stock, by current stock market conditions and the overall state of the economy.

The caution that past performance is no guarantee of future profits is absolutely valid, especially for stocks. Investing isn’t about balancing risk with reasonable expectations of reward.

Dividends

If a corporation makes a profit (earnings), the board of directors has the option to reinvest the profit back into the corporation and/or pay it out to the shareholders. The money paid to shareholders is called a dividend.

Generally, larger and older corporations pay more dividends than younger and smaller ones. Often newer and smaller companies need the profits to help grow the business.

If you are dependent on dividends for your groceries and if the price of food continues to rise, you must increase your income or reduce your intake. Most of us would probably be a lot healthier if we did the latter, but we have a tendency to reject this alternative. Therefore, you will want to select stocks that pay good dividends consistently.

We prefer stocks that have raised their dividends in at least eight of the past ten years and whose dividends today are 100 percent higher than they were ten years ago. We also prefer those that have held their dividend payout to less than 60 percent of earnings and have kept their debt under 25 percent. A record of strong and consistent dividends points to companies that are committed to similar performance in the future.

Holding payouts under 60 percent of earnings helps eliminate companies that don’t retain enough earnings to sustain growth. Keeping long-term debt low protects future earnings. But don’t reach too far for yield and jeopardize your capital. Usually the reason for the high yield is the poor evaluation that the market has given to the future prospects of the company, or it may be paying out an inordinately large percentage of its earnings, which could adversely affect future earnings. 

So in selecting stocks for dependable income, it is obvious that you will want to choose quality issues with long established dividend records rather than younger, less tested companies that have not been in business long enough to establish extended dividend payment records.

During times of market corrections, we often have calls from less sophisticated holders of income stocks who are worried that their dividend will be cut because the market price is down. If all is well with the company, we try to calm them with the explanation that short-term market prices often have no relationship to earnings. In the long term, however, they usually do.

Blue Chips

The stocks we have just described would generally be called blue chips. What is a “blue chip” stock? First, the name can be traced to the game of poker, in which there are three colors of chips: blue for the highest value, red for the next in rank, and white for the lowest value.

Occasionally someone will come into my office and say “I only invest in blue chip stocks and throw them in a drawer and forget about them.” We consider this approach to be very risky. I would prefer to see them monitor their holdings on an ongoing basis. In today’s investment world, a particular stock can drop over 50% in one day if they happen to report poor earnings or bad publicity is reported on the company.

In summary, if your desire is for income from stocks, you should: 

·         Look for companies that have a long, unbroken dividend record.

 ·         Don’t reach too far for yield and jeopardize principal.

 ·         Remember that too high a yield can be dangerous and misleading.

 ·         Favor companies producing consumer goods and services.

 ·         Select sound companies that continue to increase their dividends.

Make sure you do your homework carefully before buying any income stocks. Read the research reports and look for any potential problems the company may be having or expected to have in the future. If you do not need income now, consider companies with slightly lower yields. Often these companies are plowing back a larger portion of their earnings into expanded facilities that should in time yield higher earnings that would allow them to pay out higher dividends.

Yield

The yield on stock is the relationship of the dividend it pays to its market price. Every shareholder is entitled to the same dividend per share. However, the price you have paid for your stock may differ from the price paid by another shareholder. If you paid $50 for a share of stock and the dividend is $2, the yield on your original investment is 4 percent ($2 divided by $50). If you paid $35, the $2 represents a return, or yield, on your original investment of slightly more than 5.7 percent. You should, however, continue to calculate your yield on current market price, because you have the option of repositioning your assets.

Growth Stocks

A growth company is usually one that is increasing its sales and earnings at a faster rate than the growth rate of the national economy. The growth investor is not as focused on earnings and dividends as the income investor.

To be a successful investor in growth stocks, you must be aware of current events: supply and demand, general market trends, psychology, and money markets. In fact you must be truly current in all respects. One of the most stimulating characteristics of my profession is that every day is a new day in the market. Nothing remains static. There is no way you can be a truly top-notch investor by buying blue chips and throwing them in a drawer and forgetting about them. This only increases your risk and lowers your opportunity for gain.

There are two irreversible structural changes occurring in the United States that are permanently transforming our economic base. First, our transformation from a smokestack to a microchip economy. Second, the United States is no longer an economic fortress unto itself, but rather now a part of a global economy. And its potential for growth is boundless because its new thrust comes from our richest and most renewable resource—the human mind. 

Exchange Traded Funds

At the most basic level, exchange traded funds (ETFs) are just what their name implies: baskets of securities that are traded, like individual stocks, on an exchange. They currently trade on the American Stock Exchange.

An ETF is an investment in a particular stock index. For example, there are ETFs that invest in the stocks that comprise the Dow Jones Industrial Average, Standard & Poor's 500, and Nasdaq 100. You can also invest in ETFs that invest in certain industry sectors, such as technology, health, energy, or transportation.

Unlike regular open-end mutual funds, ETFs can be bought and sold throughout the trading day. They trade like stocks instead of mutual funds that trade at the end of the day. They can also be sold short and bought on margin—in brief, anything you might do with a stock, you can do with ETFs. Most also charge lower annual expenses than even the least costly mutual funds.

All currently available ETFs are passively managed, tracking a wide variety of sector-specific, country-specific, and broad-market indexes. Their passive nature is a necessity: The funds rely on an arbitrage mechanism to keep the prices they trade at roughly in line with the net asset values of their underlying portfolios. For the mechanism to work, potential arbitragers need to have full, timely knowledge of a fund's holdings. Active managers, however, are loath to disclose such information more frequently than the Securities Exchange Commission requires them to.

Another advantage is that, because you buy and sell ETFs at your discretion, you only incur a tax liability when you decide to sell your ETFs. Investors in no-load mutual funds are beholden to the fund manager when it comes to possible tax liabilities.

Since you buy ETFs like stocks, you will incur a brokerage commission when you buy and sell ETFs. This differs from no-load mutual funds, which don't charge a commission for transactions. Thus, when buying or selling ETFs, it is important to control your transaction costs.

One last point about ETFs is worth mentioning. These vehicles can be extremely effective ways to diversify a stock portfolio with relatively small amounts of money. Indeed, a portfolio holding a few ETFs, especially ETFs that mimic a broad index (such as the S&P 500), plus a few individual stocks can be surprisingly diversified. Thus, ETFs allow an investor to hold fewer stocks. This simplifies portfolio record keeping and monitoring while still being prudent from a portfolio diversification standpoint.

Are ETFs Right for You?  

ETFs have several clear advantages over traditional mutual funds, but they aren't suitable for everyone.

Trading Flexibility

ETFs trade throughout the day, so you can buy and sell them when you want. However, the arbitrage mechanism isn't failsafe. Heavily traded issues such as SPDRs (which track the S&P 500) and QQQs (which track the Nasdaq 100) should trade right around the value of their underlying securities, but premiums and discounts can arise, especially for thinly traded funds. Moreover, it is not yet known how ETFs might behave in the face of a full-fledged market correction. It's conceivable that investors wishing to sell in the midst of such an event could have to part with their shares at prices below their net asset values.

Costs

In terms of the annual expenses charged to investors, ETFs are considerably less expensive than most mutual funds. SPDRs, for example, set their annual expense ratio to just .12%.

Still, investors need to put these numbers in perspective. On a $10,000 investment, you'd save just $9 a year by choosing an ETF S&P 500 Index fund over a mutual fund S&P 500 Index fund.

The expense advantage of ETFs may also prove to be more mirage than fact for most investors. That's because you must pay commissions to buy and sell ETFs, just as you would for stock transactions. If you plan on making a single, lump sum investment, then it may pay to choose an ETF. However, if you plan to buy or sell shares more than once a year, ETFs' cost advantage could be obliterated quickly. That may be ETFs' greatest weakness. The fund companies behind them tout ETFs' expense advantages and trading flexibility as their key benefits, but the fact remains that if you trade very much, you actually end up costing yourself far more than you would with almost any mutual fund.

Taxes

With a regular mutual fund, investor selling can force managers to sell stocks in order to meet redemptions, which can result in taxable capital gains distributions being paid to shareholders. In contrast, most trading in ETFs takes place between shareholders, shielding the fund from any need to sell stocks to meet redemptions. Furthermore, redemptions made by large investors are paid in-kind, again protecting shareholders from taxable events.

Keep in mind, however, that ETFs can and do make capital gains distributions, as they must still buy and sell stocks to adjust for changes to their underlying benchmarks.

Performance

Because they are shielded from investor trading, ETFs shouldn't suffer from having to keep cash on hand to meet redemptions, or from being forced to sell stocks into a declining market for the same purpose.

An ETF is fully invested where a mutual fund must leave some money in cash to allow for withdrawals. For example, if a mutual fund has 5% in cash for withdrawals, only 95% of the fund is growing and paying dividends as opposed to 100% of an ETF.

Summary

ETFs have a lot to offer. They're flexible and low-cost, and their underlying portfolios are protected from the impact of investor trading. There are also ETFs that address specific subsectors that regular mutual funds do not. Nevertheless, look carefully before you leap.

ETFs' cost advantage isn't always as large as it might seem, and trading costs can quickly add up, if you are dollar-cost-averaging. Particularly if you're in the market for a fund that tracks a broad index such as the S&P 500, it can make a case yet for choosing an ETF over one of the mutual-fund options.

Equity Unit Investment Trusts

Unit investment trusts (UITs) are an unmanaged portfolio of professionally selected securities that are held for a specified period of time. They were first issued in the 1960s as a way to "package" and sell portfolios of professionally selected bonds, especially tax-exempt municipal bonds. The cost of a unit is generally $1,000. During the 1990s, the UIT concept was extended to stocks.

Unlike mutual funds—which are professionally managed—equity UITs are a "buy-and-hold" investment. Securities in the portfolio are held for a pre-determined time to generate dividends and capital gains for investors. At maturity, investors can take their cash and invest elsewhere or can "roll over" their balance into a new UIT.

Like their bond counterparts, equity UITs are an unmanaged portfolio of stocks that usually remains unchanged throughout the life of the trust. Some equity UITs follow a specific investment strategy such as investing in the five or ten highest yielding stocks among the 30 stocks included in the Dow Jones Industrial Average or only in stocks listed on foreign stock exchanges.

Like mutual funds, an increasing number of equity UITs also select stocks from a particular industry sector (e.g., technology) or companies located in a particular state or region of the country. Like individual stocks, UIT dividends and capital gains are taxable, whether earnings are distributed in cash or reinvested in additional UIT units. If the value of a UIT portfolio increases, that capital gain is taxed. Most equity UITs have maturities of six years or less. Shares can be sold prior to the trust’s maturity at a price determined by market conditions.

Two advantages of equity UITs are not having to worry about changes in portfolio holdings or management and tax efficiency (low taxes because stocks in a UIT portfolio are rarely traded). A major disadvantage is their up-front cost. Equity UITs typically charge a front-end load (commission) of about 3% of the amount invested.

Mutual Funds

A mutual fund is a corporation that pools large sums of money ranging from one million to several billions of dollars, pooled from millions of individual investors, just like you, who wish to save or make money. Mutual funds are run by an individual or a team of professional money managers who invest the pool of money into stocks, bonds, or other securities. The combined holdings of a mutual fund are known as the fund's portfolio.

An individual who owns shares in a mutual fund may invest as little as $25 to $50, or as much as $2,500 or more. By investing money into a mutual fund, your money is spread out and diversified among hundreds of stocks, bonds, or other securities, minimizing risk.

You do not need to buy bonds and stocks directly. You are not limited to the volatile performance of merely one or two stocks. In addition to this, you pay minimal fees, often less than 1% of your investment (per annum), while earning money with the expertise of the mutual fund managers. But, most of all, you will certainly be making more money than leaving it in a bank account where you may actually lose spending power.

The goal of a mutual fund is to provide an efficient way for an individual to make money. There are several thousand mutual funds with different investment strategies and goals to choose from. Choosing one can be overwhelming, even though it need not be. Different mutual funds have different risks, which differ because of the fund's goals, fund manager, and investment styles.

Money from a mutual fund is made when the stocks, bonds, or other securities increase in value (a capital gain), issue dividends, or make interest payments. When investing in a mutual fund, the income you make is the result of income received from dividend-paying stocks, and interest from bonds. If the fund sells a holding whose value has increased, you make money. Even if the fund does not sell that specific holding, the fund itself will still increase in value, and in that way you may also make money. Therefore the value of the shares you hold in the mutual fund will increase in value when the holdings increase in value. Capital gains and income or dividend payments are best reinvested for younger investors.

Retirees often seek the income from dividend distributions to augment their income. With reinvestment of dividends and capital gains distributions, your money increases at an even greater rate. When you redeem your shares, what you receive is the value of the shares.

What Is A Mutual Fund?

Although their popularity has mushroomed in recent years, mutual funds have been around a long time. The oldest mutual funds in existence today are more than 70 years old, having survived the Great Depression, World War II, and other turbulent economic and political events. In all, investors have entrusted more than $5.5 trillion to more than 12,000 mutual funds in the United States. (Source: Investment Company Institute, December 2001.)

Before making any investment, you should try to learn as much as you reasonably can about the asset you plan to purchase and how it works. Many different types of mutual funds are offered to individual investors, and the characteristics of each type will determine whether it is appropriate for your investment goal—whether it be funding your retirement, paying college tuition, or some other purpose.

The idea behind the mutual fund is simple: Many people put their money in a fund, which invests in various types of securities to pursue a specific financial goal. Then, each investor shares proportionately in the income or investment gains and losses that the fund's investments produce. Because investors may sell their shares or buy new shares each business day, mutual funds are called "open-end investment companies."

Each mutual fund has a manager, or investment advisor, who directs the investing of the fund's assets according to the fund's objectives. Some common objectives of mutual funds are long-term growth, high current income, stability of principal (the amount of your own money that you put into an investment), or some combination of the three. Depending on its objective, a fund may invest in common stocks, bonds, cash investments, or a combination of these three types of financial assets.

Major Fund Categories:

Fund Objectives/Goals:

Types Of Mutual Funds

Making Money With Mutual Funds

Of course, when you invest any money there is always some degree of risk, but the bottom line is this: in the long run, stocks bonds and other securities increase in value and make money. In the short term, stocks are volatile. The amount of volatility, if any, depends on the nature of the stock. Stock issued by large and established companies are less volatile, steady growers. Stocks of new and smaller companies tend to have more volatility but greater growth potential over the short run.

The volatility and aggressiveness of a mutual fund also lies with the manager's investment strategies. These will be described in the individual mutual fund's prospectus—an informational booklet that describes a fund’s returns, risks, portfolio, and investment strategy.

One way investors insure their failure and doom is to become nervous and sell out as soon as the value of the investment drops. In the short term, fluctuations in the value are normal and are to be expected. Do not sell on down fluctuations, because down fluctuations will almost certainly go back up, in the near to immediate future.

You probably have heard of market crashes. But, if you had kept your investments in the stock market of the Great Crash of 1929, instead of pulling out at a loss, you would have eventually recovered your loss and much more! Remember this, mutual funds are never as volatile as stocks themselves, because of the fact that a mutual fund consists of a portfolio of several stocks it is practically impossible for all to go down, even in a market crash.

When the investors all pulled out their money, instead of holding out, they contributed to the declining prices of the stock, which contributed to the severity of the crash and the Great Depression. Investor panic and the "herd mentality phenomenon" essentially resulted in the Great Depression, which could have been avoided.

Once you are invested into a mutual fund, when to sell becomes another important issue. A bad mutual fund is a fund that does consistently poorly, losing money, even in a good market when other mutual funds are making money. These funds can easily be avoided in the first place, by comparing their five-year return averages with other mutual funds.

A simple rule to follow is this: if the three to four year return is negative, do not buy the fund in the first place. If you check your mutual fund's performance every day, either through the phone, newspaper, or computer on-line service, and see short-term volatility, don't pull out, this is normal.

If you are seeking a specific goal, and have attained the amount desired, then pull out that amount of money. Partial redemptions can easily be made, usually over the phone if you desire.

Money invested in mutual funds for the purposes of retirement—in  IRAs (individual retirement accounts) or 401k plans (company retirement plans)—can be withdrawn at age 59½ without any taxes. Withdrawing early will incur a heavier tax penalty.

The Advantages Of Mutual Funds

There are four key attributes that help make mutual funds America's most popular medium for investing.

Diversification

A single mutual fund may hold securities from hundreds of different issuers, a level of diversification that few investors could achieve on their own. By pooling their money, mutual fund shareholders are able to spread their assets among many different securities, sharply reducing the risk of loss from problems with any one company or institution.

Professional Management

A professional investment manager—who has access to extensive research, market information, and skilled securities traders—decides which securities to buy and sell for a mutual fund. Professional management can be a valuable service, because few investors have the time or expertise to manage their personal investments on a daily basis or investigate the thousands of securities available in the financial markets.

Liquidity

Shares in a mutual fund may be sold whenever you want. At your request, a fund is required to redeem shares any business day, based on that day's closing price—at the net asset value. Net asset value is the share price, or market value, of a fund's total assets, less its liabilities, divided by the number of shares outstanding.

Convenience

Mutual funds offer a variety of services that can make investing easier. Fund shares may be purchased or sold by mail, telephone, or by the Internet, and your money can easily be moved from one fund to another as your investing needs change. You may arrange to have automatic investments made into a fund to steadily build an investment portfolio, or to redeem some of your shares automatically to meet monthly living expenses. You can have distributions of fund income paid directly to you or automatically reinvested in more shares of your fund. Extensive record keeping services are provided to help you track your transactions, assist you in completing your tax returns, and follow your fund's performance. You can monitor the price of your fund shares daily in newspapers, by telephone, or via a variety of online services.

The Disadvantages Of Mutual Funds

There are some disadvantages associated with investing in mutual funds that you should consider before investing.

No "Guarantees"

Unlike bank deposits, mutual funds are neither insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other agency of the U.S. Government. The market value of a mutual fund may fluctuate, even if the fund invests in government securities. Mutual funds are regulated by the U.S. Securities and Exchange Commission (SEC) and by state securities officials, who require funds to provide full disclosure of information an investor needs to make an informed decision. But this regulation does not eliminate the risk of an investment falling in value.

The Diversification "Penalty"

Because a mutual fund typically holds a large number of securities, fund shareholders give up the chance to earn the higher returns that are sometimes achieved by holding a single security or a handful of individual securities. In other words, just as diversification eliminates the risk of catastrophic loss from holding a single security, it limits the potential for a "big score" from holding a single stock or bond whose value shoots up. It also is important to understand that diversification does not protect an investor from the risk of loss from an overall decline in financial markets.

Potentially High Costs

Mutual funds can be a lower-cost way to buy securities when compared with buying individual securities through a broker. However, a combination of sales commissions and high operating expenses at some funds may offset the efficiencies that can be gained through mutual fund ownership. It's important for you to compare the costs of mutual funds that you are considering, because high costs can significantly erode the returns you receive as a shareholder.

The Nuts And Bolts Of Mutual Funds

People invest in mutual funds because they have specific goals they want to reach, such as building a nest egg for retirement, putting a child through college, or saving for a major purchase. Understanding how funds work and how they can help investors reach their goals will help you choose the investment most appropriate for your situation.

There are two basic ways a mutual fund investor may make money from fund shares: current income and capital gains.

Income

A mutual fund may produce current income for its shareholders from the fund's investments in interest-bearing securities—such as bonds or cash investments—or from dividends paid on common stocks owned by the fund. Such income, whether earned as interest or dividends, must be paid out each year to fund shareholders in the form of income dividends. Depending on the fund, income dividends may be paid monthly (for money market funds and bond funds), quarterly (for many balanced funds and stock funds), semiannually, or annually. Fund shareholders can choose to receive income dividends in cash or to have the dividends reinvested in more shares of the fund. A shareholder designates the method of payment when an account is opened, but may change the selection at any time.

The annual income produced by the fund, expressed as a percentage of the fund's current market value, is known as its yield. For example, a fund with a share price, or net asset value, of $20 that pays out $1 per year in income has a yield of 5% ($1 ÷ $20 = .05).

Not all mutual funds seek to produce investment income. For example, many stock funds—especially growth and aggressive-growth funds—primarily seek price appreciation from the securities they hold and may produce little or no income from interest or dividends.

Capital Gains

When the securities that a fund has purchased rise in value, or appreciate, the fund has an unrealized capital gain. Such unrealized gains remain in the fund, raising the market value of its shares. This gain, or appreciation, is "on paper" until an investor sells the shares.

If the fund itself sells securities at a profit, a capital gain is realized. These realized capital gains are periodically paid out to shareholders in a capital gains distribution. When a fund pays out its realized capital gains, the fund's share price is reduced by the amount of the distribution since the shareholders, not the fund, now have the proceeds. As with income dividends, the proceeds of capital gains distributions may be received by a shareholder in cash or reinvested in more shares of the fund.

Of course, stocks and bonds fall in value as well as rise, and funds from time to time may incur capital losses, which reduce the market value of fund shares. Likewise, an individual investor may suffer a loss by selling shares for a price lower than the investor paid for them.

Measuring Mutual Fund Performance

Figure 1

A mutual fund's investment performance is best measured by its total return. A fund's total return is the change in the value of an investment in the fund, taking into account any change in the fund's share price during the period and assuming the reinvestment of income dividends and capital gains distributions. Figure 1 shows the average annual total return for cash investments, bonds, and common stocks from 1926–1998, how much of that return came from income, and how much from capital gains (or capital losses, in the case of long-term bonds).

Total return may be negative if a fund's share price has declined during the period being measured. Figure 2 provides an example of how to calculate a fund's total return.

Figure 2

Total Return Calculation   Purchase price (per share)…............................ $50 Income distribution………………..................... $2 Capital gains distribution…………..................... $1 Share appreciation (shares now worth $52)........ $2     Total Return   Income + Capital Gains + Appreciation Original Purchase Price   $2 + $1 +$2     =       $5     =    10%                         $50                     $50

 

This example assumes that only one investment was made over a single period.

Total return is commonly presented in two ways. One way is called the fund's cumulative total return, or the total rise in the value of a fund's shares over time, assuming that dividend and capital gains distributions were reinvested.

The other way is called average annual total return, which is the compounded total return it would take each year to produce the fund's cumulative total return. Seemingly modest annual returns can be converted, through the power of compounding, into impressive cumulative returns. For example, an average annual total return of 7% would, after ten years, amount to a cumulative total return of 97%.

The Power Of Compounding

Compounding is when you earn interest, dividends, or capital gains on both your original investment and on the reinvested earnings of your investment. As Benjamin Franklin put it many years ago: "The money that money makes, makes money."

The steady but powerful effects of compounding are why it is so important to begin investing as early as possible in pursuit of your goal, whether that goal is retirement, financing college, or saving for a down payment on a house.  

Figure 3

Consider, for example, a single investment of $3,000 in a mutual fund that earns an average annual total return of 8%, after taxes. As Figure 3 shows, if someone invested $3,000 at age 55 and all earnings were reinvested, it would grow to $6,480 in ten years when the investor reaches age 65 and retires. If the investor had instead invested $3,000 at age 35 and reinvested all earnings, the amount would have grown to $30,190 at retirement, a difference of $23,710, or nearly eight times the original investment.

It is never too late to start an investment program, but it is clear that the earlier you start, the more benefit you will derive from compounding.

Evaluating Fund Performance

The best way to check the performance of your mutual fund is to compare its total return with the returns of similar funds or with the return of an appropriate market index or benchmark over the same time periods.

A stock fund should be compared with other similar stock funds—ones that invest in the same types of companies.

A bond fund should be compared with bond funds that invest in bonds of similar maturities and credit quality.

You would want to compare a long-term U.S. Treasury bond fund with other funds holding long-term Treasury bonds, not with funds that hold short-term bonds or mortgage-backed securities. You can usually find the name of the appropriate market index in a fund's prospectus or annual report.

When comparing funds, it is best to focus on long-term performance because financial markets—and the economy, for that matter—tend to go through cycles that can last for several years. For example, small-company stocks (and funds investing in such stocks) will at times outperform large-company stocks (and large-company funds).

At other times, the large-company stocks will be the star performers. A common mistake investors make is to constantly "chase" the best-performing funds from the recent past. Unfortunately, last year's "hot" sector of the financial markets is likely to be replaced this year by a different sector. Sadly, some mutual fund companies encourage this practice with advertisements that trumpet performance from the recent past, while simultaneously conceding (usually in small print) that past performance is no indication of future results.

Fund Expenses

Risk and return are not an investor's only considerations. Another critical factor is cost. Expenses have an important impact on your investment results. All mutual funds have expenses, but some funds are much more costly to own than others. Once you understand fund expenses, you'll find it easier to select the most cost-effective funds.

Fund costs fall into two categories: sales charges, or "loads," and operating expenses. Not all mutual funds impose loads, but all funds have ongoing operating expenses that are deducted from the income each fund earns before that income passes through to fund shareholders.

Sales loads may be charged up front as a percentage of the sum you invest. These front-end loads range from 4% to 6%. Funds that charge sales fees ranging from 1% to 3% are called "low-load" funds. Another form of sales charge is the back-end load, which is applied when an investor sells fund shares. Back-end loads, also called contingent deferred sales charges, may be as high as 6% for a redemption that takes place within a year of the original investment. The charge typically declines over time, disappearing by the seventh year after the original purchase of fund shares.

All funds incur expenses from basic operations—including investment advisory fees, legal and accounting services, postage, printing, telephone service, and other costs of running the fund. These expenses are paid from income earned by the fund. The total of these costs is known as the expense ratio, which is expressed as a percentage of the fund's average net assets during the year. This annual expense ratio typically ranges from a low of about 0.20% (or $2 per $1,000 in assets) to 2% ($20 per $1,000 in assets).

Some funds add to their operating expenses a 12b-1 fee, which goes to pay marketing and distribution costs of the fund. This 12b-1 fee, which is sometimes used instead of a sales load to compensate salespersons, can be as much as 1% of assets, or $10 each year for each $1,000 invested. Funds that are sold without 12b-1 fees or sales loads are called pure no-load funds.

How Costs Affect Returns

All mutual funds have expenses, but some are much more costly to own than others. And there is no evidence that higher costs lead to better performance. You should pay careful attention to all the fees and expenses charged by a fund because they directly reduce your investment return.

Paying a load or higher operating expenses might make sense if the end result were higher returns to the investor. But paying more to purchase shares or to operate a fund does not necessarily mean that you receive better investment management. According to William Sharpe, recipient of the Nobel Prize in Economic Sciences: "There is virtually no evidence to suggest that funds with higher expense ratios do better, before expenses. Which therefore suggests they will do worse, after expenses."

How To Compare Fund Costs

It is easy to research the costs of a mutual fund. The SEC requires that information about sales charges and operating expenses be disclosed in a document called the prospectus, which must be given to all investors at or before the time of purchase. The information about sales charges and expenses is spelled out in a fee table near the front of the prospectus. This table makes it easy to compare the costs of one fund with those of another.

Constructing Your Investment Portfolio

How you divide your investments among stock, bond, and money market funds will largely determine your long-term investment returns and the volatility (short-term variability) of those returns. For instance, stock funds can be expected to provide much higher long-term returns than money market funds, but they also fluctuate quite a bit in value. Having a mix of the different types of investments can help to offset the volatility of the financial markets because one type of asset might be rising when another is falling. This cushioning effect makes it easier for investors to continue with a long-term investment plan even during a sharp downturn in the stock market.

Choosing an appropriate mix of investments for a specific financial goal is known as asset allocation. Because investors usually have several goals, they often think of their investments as a collection of separate portfolios, each designed for a different goal.

When selecting an asset allocation, consider four factors:

Your Goal

This is simply a purchase or series of expenditures you want to make at some time in the future. For instance, one goal might be to make a down payment on a house, while another might be to ensure financial security in retirement.

Your Time Horizon

This is the number of years you have to invest before reaching your goal, including the period during which you are spending your investment. The time horizon for making a down payment on a house might be two or three years, while the time horizon for retirement might be 40 years, including your years in retirement.

Your Risk Tolerance

This is the ability to endure the inevitable fluctuations that come with investing. Knowing that you have many years to reach a goal may make you more comfortable with investments, such as stocks, that are likely to provide higher long-term returns but also have higher risks. Keep in mind that you can't avoid all investment risks, and, if you select only very stable investments, you run the risk of losing purchasing power to inflation.

Your Financial Condition

This is the stability of your job and the state of your personal finances. A person with a steady job and well-established investment programs can afford to take on more investment risk than someone with an unstable job and few assets.

Rebalance Your Portfolio

Because stock, bond, and money market investments will each provide different returns, you may need to "rebalance" your portfolio over time—moving assets from one fund to another to maintain the desired asset allocation.

If you do not rebalance, you could end up with a portfolio that carries more risk than you want or that is not likely to fulfill your financial goals. Keep in mind that if you rebalance by selling one type of asset and buying another, you may incur an income tax liability and you may have to pay fees and commissions.

You may want to review your asset allocation each year to make sure it is still appropriate. As your time horizon decreases, consider gradually changing your investments to a more conservative mix.

Build Your Portfolio With One Or More Funds

In selecting mutual funds that best match your asset allocation plan, you could select stock and bond funds to create a portfolio of funds, or you could choose a balanced fund, which is a single mutual fund that invests in stocks, bonds, and (sometimes) cash investments.  In many cases this is a good strategy for someone just starting out with a small amount to invest. Many balanced funds maintain a fairly stable mix of such assets.

Fund Style

Two important considerations when choosing funds are deciding whether to use:

• An "actively" managed fund or an index fund.

• A taxable fund or a tax-advantaged fund.

Your portfolio can be built using either actively managed funds or index funds, but you should understand the difference before selecting one. Actively managed funds seek to produce investment returns that exceed a target market average, such as the Standard & Poor's 500 Index (the S&P 500) by researching and selecting specific securities. The alternative approach—an index fund—holds securities in the same proportion as that of a market index (or average) in order to closely match the index's performance.

Some investors favor an actively managed fund in hopes that it will provide above-average returns. Others prefer an index fund because few professional managers can beat the market consistently. Over the last ten years, the overall U.S. stock market (as represented by the Wilshire 5000 Equity Index) has outperformed 82% of all actively managed stock funds, according to fund researcher Lipper, Inc.

Some investors are unsure which investment approach is best, so they hedge their bets by owning both actively managed and index funds. It’s a good idea to diversify with both styles of funds.

Taxable Versus Tax-Advantaged Funds

Most mutual funds are not managed with an eye on the impact of taxes, but some funds are tax-friendly by nature. For example, a stock fund that buys and holds securities rather than actively trading them is less likely to realize taxable capital gains that must be passed along to fund shareholders.

Stock index funds—by pursuing a buy-and-hold strategy—can reduce an investor's exposure to taxes. Some other funds, called tax-managed funds, take indexing a step further to minimize taxable gains and income through strategies that include low turnover, careful selection of shares to sell at a loss to offset capital gains, and redemption fees to discourage short-term investing and market-timing that can hurt the other investors in the fund.

You can receive tax-free income by investing in municipal money market and bond funds, which invest in securities issued by state and local government entities. The interest earned through these funds is generally exempt from federal income taxes and, in some cases, from state and local taxes. These funds are also known as tax-exempt funds. Keep in mind that, while interest income is tax-exempt, you may still incur taxable capital gains through an investment in a municipal bond fund.

Tax-exempt funds are typically appropriate only for investors in a high tax bracket because they pay lower yields than taxable funds—and that lower yield could easily offset any tax advantage. To determine if a tax-exempt fund is a good choice, you should compare its yield (not total return) with the after-tax yield you would receive from a comparable taxable fund. Tax-exempt funds should never be used in a tax-deferred account such as an individual retirement account (IRA), Roth IRA, or 401k. The reason for this is that retirement accounts already grow tax-deferred.

Taxable Versus Tax-Exempt Bond Funds

To decide if you should invest in a taxable fund or a tax-exempt fund, use this formula to determine the "taxable-equivalent yield" of the tax-exempt fund.

Tax-exempt yield ÷(1 - your federal tax rate*)= Taxable-equivalent yield  

*In decimal form. For example, 0.31 if in the 31% bracket.

If the taxable-equivalent yield is higher than the yield on a taxable fund with a similar maturity, then you may wish to invest in the tax-exempt fund. Bond fund investors should check their marginal tax rates each year to determine if a tax-exempt fund or a taxable fund is appropriate.

Note: Income received from a tax-exempt fund may be subject to state and local income taxes or to the federal alternative minimum tax. If you invest only in municipal bonds from your state, the interest income may also be exempt from state and local income taxes. In that case, add your marginal state and local tax rate to the federal rate in the formula above.

How To Read A Mutual Fund Prospectus

A recent survey of retirement investors revealed some significant misperceptions about mutual funds:

Nearly 90% of investors surveyed didn't know that money market mutual funds contain only short-term securities.

About 75% of respondents didn't know it's possible to lose money in a government bond fund.

Almost half of respondents didn't know that they could lose money in a bond fund.

Fortunately, there's a tool designed to thwart such misinformation—the mutual fund prospectus. Wading through this sometimes complex document, however, may take perseverance and a strong cup of coffee.

Think of the prospectus as your travel guide to the world of mutual funds—it provides all the details you need to map out a successful investment plan. At first glance, of course, a prospectus may not look as reader-friendly as you would hope. It is, after all, a legal document that must adhere to rigorous standards set forth by the Securities and Exchange Commission (SEC), the federal agency that oversees the mutual fund industry.

With a little basic knowledge of the information contained in a prospectus, you can make effective use of this valuable investment-planning tool.

Questions To Ask Before Investing

• What does this fund invest in?

• What is the long-term rate of return?

• How much has return fluctuated in the past?

• How does the fund's performance compare with that of the underlying market?

• Is the fund seeking income or capital growth?

• What time frame is appropriate for an investor in this fund?

• What are the costs involved with this fund?

How Can A Prospectus Help You?

 
Consider these examples of hypothetical situations in which the information found in a prospectus could have been very useful:

An investor sells his mutual fund shares and is surprised to learn that a portion of the sale price is paid to the fund company in the form of a back end load.

An investor exchanges her investment in one fund for another fund in the same fund family. She did not know that fees were charged for the exchange.

A retiree in search of income invests in a high-yield bond fund but doesn't know it is also high-risk and is disturbed by its fluctuating value.

Attempting to make a mortgage payment with money from a money market account, an investor discovers that the fund places a minimum amount on its check writing privilege.

All of the necessary information to prevent these occurrences is contained in every mutual fund's prospectus.

Take a look at these key elements:

Date Of Issue — First, verify that you have received an up-to-date edition of the prospectus. A prospectus must be updated at least annually.

Minimum Investments — Mutual funds differ both in the minimum initial investment required, and the minimum for subsequent investments.

Investment Objectives — The goal of each fund should be clearly defined—from income with preservation of principal to long-term capital appreciation. Be sure the fund's objective matches your objective.

Investment Policies — A prospectus will outline the general strategies the fund managers will implement. You'll learn what types of investments will be included, such as government bonds or common stock. The prospectus may also include information on minimum bond ratings and types of companies considered appropriate for a fund. Be sure to consider whether the fund offers adequate diversification.

Risk Factors — Every investment involves some level of risk. In a prospectus you'll find descriptions of the risks associated with investments in the fund. Refer to your own objectives and decide if the risk associated with the fund's investments matches your own risk tolerance.

Performance Data — You'll find selected per-share data including net asset value and total return for different time periods since the fund's inception. Performance data listed in a prospectus are based on standard formulas established by the SEC and enable you to make comparisons with other funds. Remember that past results do not guarantee future performance. When evaluating performance, look at the track record of a fund over a time period that matches your own investment goals.

Fees And Expenses — Sales and management fees associated with a mutual fund must be clearly listed. The prospectus will also display the impact these fees and expenses would have on a hypothetical investment over time.

Tax Information — A prospectus will include information on the tax status and implications of a fund's distributions—whether they will be treated as dividend income or capital gains.

Investor Services — Shareholders may have access to certain services, such as automatic investment of dividends and systematic withdrawal plans. This section of the prospectus, usually near the back of the publication, will describe these services and how you can take advantage of them.

The Summary Prospectus

The Securities and Exchange Commission recently approved use of a simplified summary prospectus to help investors better understand key characteristics of a mutual fund investment.

Ask your mutual fund company for a summary prospectus in
addition to the regular prospectus.

To simplify the process of reviewing mutual fund prospectuses, certain information is required to appear in the same place. For example, the fee table and performance table must appear at the beginning of the prospectus.

While the rest of the material can appear in any order, you'll generally have no trouble finding the information you need. Prospectuses generally range from 10-20 pages and include a table of contents. And after reviewing a few prospectuses, you'll become accustomed to the language and be able to reduce the time it takes to find the information you need to make a sound investment decision.

You can receive prospectuses free from mutual fund companies, a broker, or a registered representative. Be sure to read the prospectus and ask questions about items that you are not sure about before investing. Your financial planner or broker should be able to answer any questions.

Real Estate

Real estate is one of the best investments you can make, but you must know what you are doing. Just because a home is a good investment does not mean it’s a “sure thing.”

When you buy a home, you are probably making one of the largest investments you will ever make, so you need to totally understand the basics of making such a purchase. If a home is bought in the right location and at the right price, it can be very worthwhile. But, if you make a mistake in either of these areas you can suffer financially.

When you buy real estate for use as rental property, you can benefit by the purchase in at least three ways: it provides current income; it provides tax benefits through business expense deductions and depreciation; and, if you like, it can provide a place to live when you retire.

Let’s consider first the tax benefits that result from offering property you own for rental purposes. First, any expenses you incur in operating the rental property are deductible from your income as business expenses. These might include repair and maintenance of the house or other property, interest payments on a mortgage, or an occasional trip to inspect the property if it is outside the area where you live.

Second, depreciation can be deducted from your income as well. This is the annual decline in value of any property, which results from its increasing age and is determined according to a fixed schedule depending on the nature of the property. This is a noncash deduction, since you are not actually expending any money; yet you reap the tax benefits just as if you were.

Real estate values usually increase each year rather than decrease, despite what happens in “soft” markets such as from the mid 1980s to the early 1990s. Therefore, you could say that you benefit twice: the actual resale value of your property will generally grow, while you get a tax deduction because of the theoretical decrease in the value of your property over time.

Real estate offers decided advantages to the canny investor. But like any other investment, it carries risks as well. The greatest is the risk of buying a property whose rental or resale value is minimal. My real estate agent associates tell me that the three most important rules of real estate investment are location, location, location, and that is pretty sound advice.

Another important aspect of real estate investments is the selling of your home and its tax ramifications. When you sell your home and you realize a profit, you will receive two favorable tax treatments:

1) You will be able to postpone the tax on the profit indefinitely if you purchase another primary residence within 2 years.

2) Before May 1997, a one-time tax exclusion of $125,000 was available to those over the age of 55 while other homeowners could be taxed on any profit from the sale of their home as capital gains. Under the Taxpayers Relief Act of 1997 that exclusion, regardless of age, has been raised to $500,000 for gains on the sale of the home for married couples and $250,000 for single filers as long as the property was held as a primary residence for two of the past five years. However, homeowners can no longer plow gains in excess of the exclusion into a new house.  

REIT

If you’re interested in real estate but somewhat hesitant to get involved directly, consider a real estate investment trust (REIT). It is the simplest and most direct way to invest in real estate. Like a mutual fund, a REIT pools money from many investors who buy shares in the trust’s portfolio. However, rather than investing in stocks or bonds, a REIT invests in real estate.

Purchasing a REIT could be looked at as investing your money in real estate by the share instead of by the brick. When you receive shares in a trust, you are buying a stock that trades on a stock exchange just as any other stock does. Income from the rent or interest on the mortgages is paid as dividends. When the property is sold, capital gains will be given to the stockholders as a special dividend; or the sale may increase the earnings per share, thus raising the value of the stock.

A REIT may invest in various properties such as: office buildings, apartments, shopping malls, hotels, and resorts. Some REITs are regional, meaning they invest only in a city or state.

REITs have several advantages for investors. They allow small investors to participate in real estate investments that would otherwise be unavailable. Shares in a REIT are liquid and can normally be sold near their full value. They are a liquid method of owning what is traditionally an illiquid asset and are easier to buy and sell than physical property.

As long as a REIT meets certain requirements, it pays no corporate tax. Thus, while other investments, such as mutual funds, pay after-tax dividends, the REIT can distribute pretax dollars.

REIT investments may be very conservative or highly speculative depending upon the policy set by the management of the trust. You’ll want to make sure that the objectives of the trust match your own investment plans before you get involved.

Precious Metals

Gold and silver has been used as money since biblical times. It has several characteristics that make it desirable as a medium of exchange. Gold is scarce and it is durable. More than 95 percent of all the gold ever mined during the past 5,000 years is still in circulation. And it is inherently valuable because of its beauty and its usefulness in industrial and decorative applications. 

One advantage of precious metals as a currency is that they can’t be debased by the government. With a paper-based currency, such as U.S. dollars, the government can print more to pay off debts. This process can lead to the devaluation of a currency and inflation.

One hundred years ago one ounce of gold would buy about one average men’s suit. Today at about $300 per ounce, one ounce of gold will buy—you guessed it—one average men’s suit. With all the fluctuations in price, the real value of gold hasn’t changed in a hundred years. 

Why Is Gold Considered An Investment?

Scared investors often invest in precious metals as a hedge against economic collapse or hyperinflation. They read some of the many doom-and-gloom books available and think back to the Great Depression and then insist on buying gold to protect them. 

Gold has long been referred to as the “doomsday metal” because of its traditional role as a safeguard against economic, social, and political upheaval and the resulting loss of confidence in other investments, even those guaranteed by national governments. Yet this may not be true, as was seen during the stock market crash of 1987 when the price of gold was expected to soar. As you may be aware, nothing occurred to its price even though the volume of sales increased 300 percent. Gold prices also remained relatively stable after the terrorist attack on September11, 2001.

Commodities

At the very top of the investment risk pyramid are commodities. These include bulk goods and raw materials such as pork, grain, coffee, sugar, cocoa, metals, etc. The term also describes financial products, such as currency or stock and bond indexes, that are the raw materials of trade.

Commodities are bought and sold on the cash market, and they are traded on the futures exchanges in the form of futures contracts. Commodity prices are driven by supply and demand: when a commodity is plentiful—corn in August, for example—prices are comparably low. When a commodity is scarce because of a bad crop or because it is out of season, the price will generally be higher.  

Financial expert Andrew Tobias says that since 90% of the people who speculate in commodities lose (and 98% may be a more accurate figure), the key is how to be among the 10% or (2%) who win. He simply compares investing in commodities to gambling. At the top of the investment risk pyramid, you have high potential for return, but also high risk. To invest there, you need to be able to afford to lose your entire investment.

Costs include brokerage fees. You also need considerable knowledge of the commodity in question and the markets in which it is created and sold as well as the changing situations of the buyers.

Annuities

An annuity is a contract between you (the annuity owner) and a life insurance company. In return for your payment, the insurance company agrees to provide either a regular stream of income or a lump sum payout at some future time (generally, once you retire or pass age 59½ ).

Your premiums are invested in one or more security portfolios and fixed interest accounts, where they earn interest and/or capital appreciation. No taxes are due until these earnings are paid out. If you make a withdrawal before age 59½, you could incur a 10% tax penalty.

All annuities have several things in common:

1. Inside the annuity, the money compounds tax-deferred. Beyond this, each annuity has its own cost structure, characteristics, and rate of return. Taxes are paid on the earnings when money is withdrawn at retirement either in a lump sum or as a series of periodic payments.

2. There is no tax deduction for the money used to purchase the annuity (exception: IRAs, retirement accounts, and tax-sheltered annuities in 403b plans).

3. If the annuity holder (investor) dies during the accumulation phase, that is, before receiving any payments from the annuity, the beneficiary is guaranteed to receive the amount of the original investment.

Annuities are sold by commissioned sales persons such as: bankers, stockbrokers, financial planners, insurance agents, or through mutual funds, but regardless of who makes the sale, an insurance company always backs the annuity.

Definition Of Annuitize

Choosing to receive payments at regular intervals over time is "annuitizing." Most companies offer several annuity options, based primarily on how long you want the income to last.

How is the amount of the payment/withdrawal determined if it’s annuitized? First, the insurance company converts the accumulation units to "annuity units," which allow payouts that are partly a tax-free return of principal and partly taxable earnings. Meanwhile, the undistributed portion of the investment continues to compound, tax-deferred. The amount of each payment will depend on the annuity option selected, annuitant’s age, the number of annuity units, and the performance of the securities in the portfolio(s) selected.

An annuity may be either an immediate annuity or a deferred annuity.

Immediate Annuities

An immediate annuity pays a lifetime income starting now. In return for a lump sum of money, the purchase of an annuity guarantees a fixed income for life.

Deferred Annuities

A deferred annuity allows the annuitant to initially purchase accumulation units prior to the payout period.

Deferred annuities may be purchased in one of two ways. Single premium annuities are purchased with a lump sum and flexible payment annuities may be purchased by installment payments over a period of years.

Deferred annuities accumulate money for the future and come in two types. A fixed annuity pays a specified interest rate for a period of time. A variable annuity puts your money in stocks, bonds, or money market mutual funds, and returns are dependent on the financial market volatility and performance.

Fixed Annuities

A fixed tax-deferred annuity is a contract between you and an insurance company for a guaranteed interest bearing policy with guaranteed income options. The insurance company credits interest, and you don't pay taxes on the earnings until you make a withdrawal or begin receiving an annuity income. Your annuity contract earns a low rate of return that is safe.

Fixed annuities are like certificates of deposit (CDs) offered by insurance companies. The early withdrawal fee or penalty from a fixed annuity will be even greater than on CDs. On the positive side, tax planning can be accomplished by using an annuity to push income from this year into next year, lowering income for tax purposes.

But, once you own them for more than a year, your flexibility drops significantly. Too many people allow the unpaid tax or expense penalty to handcuff them into holding the annuity, missing wonderful investment opportunities. In the years I've been managing money, I've seen this happen much too frequently.

Variable Annuities

A variable annuity is an insurance wrapper around equity mutual fund investments. Variable refers to the fact that the market value and/or income generated by the underlying securities is not fixed; your return may vary due to prevailing interest rates and other market factors.

It allows the client investment choices in separate accounts. The separate account investments are similar to mutual funds. Choices range from very conservative options such as money market and government bonds to more aggressive choices such as medium and small company stock funds.

You pay an extra 1% to 1.5% (or more) annually for your equity fund never to be worth less than your original investment should you die prior to withdrawing the money. This is called mortality and expense charges.

The performance of your investment does not depend on the insurance company's portfolio. Only the performance of the variable portfolios you have chosen will affect your results.

You allocate your money to purchase accumulation units in different portfolios, depending upon how aggressive or conservative you wish to be.

You choose the portfolios in which you will invest from among those offered. The insurance company backing the annuity develops a relationship with a professional money manager, whose experts decide which specific stocks and bonds will be a part of each portfolio.

In some newer variable annuities, you can take advantage of the wisdom of more than one expert money manager, allowing you even more flexibility in structuring your investment.

If you'll need the money in such a short time as to not let the stock market go through its normal cycles, equities are not the place to invest. If you have long-term investment capital, which qualifies to take the risk of the stock market, you don't need to insure it.

Even if you invest in a single separate account, your risk is spread among many securities, reducing the possibility of losing a substantial amount due to any one security.

Another feature a variable annuity has is switching privileges. Most variable annuities permit you to reallocate your money among the portfolios, usually without charge as long as you don't move the money too often.

A variable annuity has two stages: the accumulation period and the payout period. The accumulation period begins as soon as you invest. You invest with one large payment if you select a single premium annuity. Or you may make one or more payments of various amounts to a flexible premium annuity. Once you make a payment, your money begins to accumulate tax-deferred earnings. Later, your principal and interest can be paid out to you in the form of a regular income or as a lump sum.

Your premium usually purchases "accumulation units" in the insurance company's separate account, which is maintained separately from the company's regular portfolio of investments. This separate account in turn purchases shares in professionally managed securities portfolios. Each unit's value or "price" is determined by the value of the portfolio, divided by the number of units outstanding.

Each unit represents a share of the total worth of the portfolio. For example, assume a $10 million portfolio has one million accumulation units: each unit has a current value of $10. If the portfolio appreciates to $12 million, the unit value rises to $12 each. Divide your premium by the unit value at the time you invest to approximate the number of units you'll purchase.

Payout Options

The payout from annuities may be taken in several ways. Ordinary taxes (not capital gains tax) are owed when the money comes out, and there is 10% penalty on earnings withdrawn before age 59½. You can take monthly payments for the rest of your life, or you can make periodic withdrawals.

If you make regular withdrawals, part of each withdrawal is treated as taxable income, and the rest is a nontaxable return of your own capital. If you make occasional withdrawals, the entire withdrawal is treated as taxable income. Taxes are levied until you have taken all of the earnings on the original capital invested. Other payment options include taking the money in a lump sum or rolling your savings into another annuity tax-free.

Because annuities are purchased with after tax-dollars, it is usually recommended that pre-tax investment plans (e.g., IRAs, 401ks) be used to the maximum first.

Surrender Fees

Like Certificates of Deposits, annuities have a penalty for early surrender, however most annuity contracts have a minimal "free withdrawal" provision.

Annuities are notorious for their lack of liquidity. When you buy an annuity, you are making a long-term commitment (15 to 20 years). Moving the money to another annuity may be difficult, and quitting is expensive. You usually have to pay a surrender fee to the insurance company for selling an annuity too soon (e.g., withdrawing money from an annuity after the third year). A common fee is 7% the first year, which is reduced to 0% by the seventh year.

For our purposes, "liquidity" refers to the ability of an investor to have unrestricted access to his/her money. For example, an investment would be characterized as "liquid" if it were available without penalty or additional fees at any time. On the other hand, an investment would be deemed "illiquid" if there were impediments to the investor accessing the money. A variable annuity falls into this "illiquid" category for two reasons.

First, the insurance company makes withdrawals costly by imposing a surrender charge of between 6 and 8 percent of the withdrawn amount. While this surrender charge phases out over time, and while most variable annuity contracts allow the owner a 10% penalty-free withdrawal annually, investors who value unrestricted access will be frustrated.

The second factor affecting a variable annuity's liquidity comes courtesy of the Internal Revenue Code (IRC). The IRC requires that if you withdraw money (in excess of the 10% annual allowance) from an annuity before age 59½, an additional 10%  penalty applies. Of course, like the insurance company's surrender charge, the IRC tempers its restriction with a limited escape clause. That escape clause says that if you irrevocably elect to annuitize the account (give up all access to principal and begin periodic distributions), the penalty is waived.

Tax Advantages

You pay no taxes while your money is compounding inside an annuity. You can also pay a lower tax on random withdrawals because you control the tax year in which the withdrawals are made, and only pay taxes on the interest withdrawn. Tax deferral gives you control over an important expense—your taxes. Any time you control an expense, you can minimize it.

The longer you can postpone this particular expense, the greater your gain when compared to the gain you would make with a fully taxable account.

Tax-Deferred

Tax-deferred means postponing your taxes on interest earnings until a future point in time. In the meantime, you earn interest on the money which you're not using to pay taxes. You can accumulate more money over a shorter period of time, which ultimately will provide you with a greater income.

To illustrate the increased earnings capacity of tax-deferred interest, compare it to fully taxable earnings. $25,000 at 6.0% will earn $1,500 of interest in a year. A 28% tax bracket means that approximately $420 of those earnings will be lost in taxes, leaving only $1,080 to compound during the next year. If these same earnings were tax-deferred, the full $1,500 would be available to earn even more interest. The longer you can postpone taxes, the greater the gain.

The Difference Of Taxable And Tax-Deferred Investments

When you invest in a taxable investment such as mutual funds, stocks, or some bonds, any dividends or interest you earn during the year are considered taxable income. Also, if you sell the investment or the mutual fund money manager sells an investment and gives you a distribution, you'll owe capital gains taxes.

When you invest in the underlying securities of a variable annuity, growth is credited to your account but is not taxed in that year. You pay taxes only on money withdrawn.

When you make a withdrawal, you'll owe income taxes at your current rate on any portion of the withdrawal that is considered growth. For tax purposes, withdrawals are always considered interest first, so unless you begin to exhaust principal, you'll owe taxes on the full amount of your withdrawal. In addition, because the IRS set up tax deferral rules in order to encourage Americans to save for retirement, if you make a withdrawal before age 59½, you're likely to owe a 10% federal tax penalty on the amount withdrawn. (Only under certain IRS-defined situations, such as disability, will you be exempt from this penalty.)

If you purchase your annuity in a qualified plan such as an individual retirement account or Keogh account, different tax rules apply. The full amount of any withdrawal, even an amount attributed to principal, is taxable. This is because in a qualified plan, the contributions to the annuity are made on a pretax basis—since you didn’t pay tax on that money in the year it was earned and invested you owe tax when you receive it out of the annuity.

No Withholding Tax

There is no withholding tax while your annuity is compounding; it is completely tax-deferred. If you request a distribution (random withdrawals or annuity income), taxes will be withheld – unless you elect differently. Your election not to withdraw can be made at the time you make your request. Because the interest is tax-deferred, it is not necessary to issue a Form 1099 while your money is compounding. Only when your interest is distributed (withdrawal or annuity income) will a Form 1099 be sent, reflecting the amount of interest actually received.

Tax Disadvantages

Many commissioned annuity sales people fail to tell the truth about the taxation of annuities. They only tell the positives.

The main part that they fail to tell you is that when money is withdrawn it is taxed as ordinary income tax. That is if you are in the 31% tax bracket you pay 31% on any money withdrawn. However, if you owned a mutual fund or stock and owned it for more than one year when you sell it you are taxed at the capital gains rate of only 20%. This is an 11% savings!

Another aspect annuity sales people fail to tell you is that if your investment drops in value, you don’t get to write off the losses against the gains. For example, you invested $10,000 in a stock and the stock price drops to $8,000 after you purchase it you could sell it and offset gains with the $2,000 tax loss.

If you would lose money in a variable annuity you don’t get the advantage of offsetting gains as you would in a standard account.

Step up in cost basis is another advantage a standard account has over the annuity. For example: you purchased a stock for $10 per share and over several years that stock grew to $40 per share. If you died while still holding that stock, your heirs would receive it at the price at the date of death (in this example $40 per share). Your heirs would avoid any capital gains taxes incurred over the years. In an annuity the heirs would have to pay ordinary taxes on any gains. 

Charitable giving is another disadvantage of annuities. For example: you purchased a stock at $10 per share and over several years that stock grew to $40 per share. You would be able to gift that appreciated stock to a registered charity and get the full tax deduction and avoid any capital gains tax.

Safety

 
The fixed tax-deferred annuity is a safe investment. A qualified legal reserve life insurance company is required to meet its contractual obligations to the annuitant.

Legal reserve refers to the strict financial requirements that must be met by an insurance company to protect the money paid in by all policyholders. These reserves must be, at all times, equal to the withdrawal value (principal plus interest less early withdrawal fees, if any) of every annuity policy. State insurance laws also require that a life insurance company must maintain certain minimum levels of capital and surplus, which provide additional policyholder protection.

When Does The Money Mature?

An annuity policy does not "mature" like a bond or certificate of deposit. Both the principal and interest will automatically continue to earn interest until withdrawn or you reach age 100. You can let your money continue to grow, make withdrawals, or begin receiving an annuity income at any time.

Spendthrift Protection

If you are someone that is a mindless spendthrift who would have spent the money frivolously if you had it as a lump sum, an immediate annuity serves the situation well since you would get payments over a period of time but no access to the principal. Better you only get monies in drips and drabs and not allow the principal to be squandered.

Additionally, annuitization could be used for many people who are not spendthrifts per se but are so lacking in basic budget planning they  tend to spend the assets well before their actuarial lifetime. But that is just being foolish.

Avoid Probate

If a premature death should occur, the accumulating funds within your annuity may be transferred to your named beneficiaries, avoiding the expense, delay, frustration, and publicity of the probate process. Like most assets, the annuity is part of your taxable estate. Your heirs can choose to receive a lump sum payment or a guaranteed monthly income.

The beneficiaries that do receive the money will need to pay ordinary tax on the funds. Annuity beneficiaries do not get the step-up in cost basis, as stocks would offer.

What Guarantees Do I Have?

The guarantee that annuity owners receive is the “guaranteed death benefit.” The insurance company generally guarantees that in the event of death before annuitization, your beneficiary will receive the greater of a) the entire amount of your premiums, less withdrawals, charges, and fees; or b) the current contract value. Some annuities provide more generous options.

Another guarantee that annuity owners receive is the “fixed interest option.” Most annuities also let you allocate funds to one or more "fixed account" options in which the insurance company guarantees your interest rate. 

Can I Have Access To My Money Before I'm 59½ ?

Most annuities provide for withdrawal of a specified amount free of charge, excluding taxes. Withdrawals in excess of the amount specified are possible but, in the early years of the contract, may trigger surrender charges. Most annuities require the annuitant to hold the funds there for at least eight to ten years.

As discussed previously, if you are younger than age 59½, the IRS may impose a 10% penalty tax.

You may also encounter a "market value adjustment" (MVA) if you withdraw money from fixed interest options before the end of the interest rate guarantee period. An MVA ensures that you receive the market value of assets withdrawn before their maturity date and may increase or decrease the value of your account.

Also, be aware that some annuities allow you to make systematic withdrawals from your account on a regularly scheduled basis, which can help in providing you with a steady income. Systematic withdrawals are subject to the same tax rules as other withdrawals.

Are Taxes Different On Payouts Than On Withdrawals?

Once you have annuitized, each payment is structured as a partial return of principal and part interest. Only the interest portion of the payment is taxable. In addition, you can annuitize over your lifetime before age 59½ and your regular payments will not be subject to a tax penalty. You should consult your financial advisor before deciding to annuitize.

What Happens If The Money Is Paid Out To My Beneficiary?

An annuity provides a death benefit that avoids probate and is paid directly to your beneficiary, thereby avoiding costs and delays. The guaranteed minimum death benefit is generally the greater of either the total amount of your premiums, less withdrawals, or the current value of your investments.

Some companies are more generous in their contracts, allowing for a guaranteed increase in the premium amount or a step-up in the guaranteed death benefit value at certain contract years. Read the literature and contract language for the annuity you choose to find out exactly what type of death benefit the company offers.

Again, remember that annuities are taxed differently than non-annuities, as discussed previously.

How Do Variable Annuities Compare To IRAs?

Annuities and IRAs both provide tax-deferred growth, but there are differences. A qualified IRA owner also receives a tax deduction on the money invested into an IRA each year.

Anyone can invest in an annuity, in an unlimited amount. With an IRA, only those with earned income can invest, and contributions are limited. Also, an annuity can guarantee you an income for life; most IRAs cannot. In addition, the IRS says you must begin taking distributions from your IRA at age 70½; most annuities do not require you to begin taking regular payments before age 85. For information on the tax deductibility aspects of IRAs, consult your tax advisor as tax laws constantly change.

What Should I Consider When Selecting A Variable Annuity?

The historical performance of the underlying portfolios, while not a guarantee of future results, should tell how well the annuity's investment manager has done in both positive and adverse markets. This is more important to the growth potential of your investment than any short-term figures.

Fees and charges should be carefully reviewed. Some annuities have a surrender charge that declines over a number of years. Others maintain a high charge for a stated period of time. No-load variable annuities are an excellent option if you feel you need to buy an annuity. Be sure to look at annual administration fees and asset charges, and find out if the insurance company charges for transfers among the portfolios. It's important that you understand the fees before you purchase your annuity.

The soundness of the insurance company is important. Find out whether the company is rated "Excellent" (A) or higher by independent industry analyst A.M. Best Company.

How Do I Get Out Of The Annuity That I'm In?

You don't get in them to begin with, truthfully. Because an annuity is a contract and in essence qualifies as insurance even though there's no insurance around while your money is in the annuity, it's called an annuity.

Many investors want to come out of the annuities because there are a few things that are happening. For those of you who are in annuities, you are stuck, because if you take your money out in one lump sum you're going to pay ordinary income taxes on it (and penalties if you’re under age  59½) and you might look to taking 10% what you can withdraw at once. Slowly but surely get it out of there. But be very careful before you get into one because they're not all that they are made up to be.

Business

Ownership of a business is another investment option. There are many different kinds of businesses and many ways to be involved. You may own and operate a business yourself or hire someone to operate it. You can start your own business or purchase a franchise of a larger business.

While businesses certainly offer opportunity for income, they also have many risks. Careful attention must be given to the financing, cash flow needs, and reserves.

For small businesses it is important to separate business expenses from the family budget. A separate checking account for the business is crucial. In many cases a more sophisticated software such as QuickBooks © may be more helpful.

Another advantage to keeping your business separate from your personal life is protecting your home and belongings during difficult financial times.

If you are considering starting a business, there are many resources to help you. For instance, in many states a cooperative extension office offers education on micro and home-based businesses. The Small Business Administration also offers assistance. Other organizations in communities and in state government have valuable resources as well.

If you are considering such an investment, search widely for information. Do your homework! The failure rate of small businesses is very high. Planning, especially development of a business plan, is critical.

Remember, running a business can be the riskiest investment you have ever made. However, if done correctly it can be the best and most rewarding venture. The truly successful people on earth are business owners.

Collectibles

People collect just about anything—stamps, coins, dolls, art, cars, and autographs. To be financially successful with collectibles as an investment, however, a high level of knowledge is required. Some people collect as a hobby and enjoy spending their time this way.

To make money with this type of investment, you need a collection of items in top condition. You probably cannot regularly use or touch the collectible and will need to safely store them in a protective environment.

Keep documented evidence of the value of your collection, (e.g. an appraisal of antiques). Regular maintenance and insurance may be necessary, too and there could be storage costs. The specific needs and the type of collectible will determine costs.

Generally, collectibles do not provide a regular or periodic income. When you sell an item, you see the gain in value. When you want to sell, it may take a while to find the buyer willing to pay what you think your collectible is worth. A professional appraiser or auction house may also be required to sell items to other investors.

As you make investment decisions about collectibles, it is important to be sure that you are truly focusing on the value of the investment and that you are not unduly influenced by the psychological pleasure you receive from owning it.

Why should a Christian investor consider hiring a Christian Financial Planner? The main reason is because the investor and advisor are both Christians, they share similar values. the advisor understands Biblical principles such as tithing, budgeting, saving, investing and giving. After the initial interview process of numerous financial related questions, the financial advisor can identify areas of improvement for the client.

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