Basic Finance Lessons

          It is easy to become confused when trying to comprehend the endless possibilities of the investment world. While it is not necessary to know the entire financial sector inside and out, it is crucial that you understand the investment vehicles that could have a dramatic impact on your personal finances. Therefore, we have provided you with a list explaining common methods of investment that are often instrumental in improving financial well-being.

INVESTMENT FUNDS

Mutual Fund: An open-ended fund operated by an investment company which raises money from shareholders to invest in a group of assets, in accordance with a stated set of objectives. The primary advantages of mutual funds are professional money management, diversification, liquidity, and a high degree of convenience and choice. Some disadvantages include maintenance fees and minimum investment requirements. Mutual funds account for more than 90% of investment company assets today.

Index Fund: A passively-managed mutual fund that attempts to match the performance of a particular market index. Individuals who typically invest in index funds believe that the combination of low maintenance fees and the diversification of the market will allow them to outperform actively-managed funds over time. Common examples of index funds are the S&P500 index fund by T. Rowe Price (ticker symbol: PREIX) or Vanguard (ticker symbol: VFINX).

Target Retirement Fund: A mutual fund designed to manage assets in accordance with the desired retirement year of investors. The only decision investors must make when choosing a target retirement fund is to select the year they intend to retire. Over time, target retirement fund managers will adjust the portfolio asset allocation to more conservative investments in compensation for your expected level of risk tolerance. An example of a target retirement fund is Fidelity Freedom 2040 (ticker symbol: FFFFX).

Hedge Fund: A mutual fund that takes significant risks, including considerable investment in unconventional instruments, with the hopes of generating greater profits than the general market. Hedge funds are often heavily engaged in options and the use of leverage and many are unregulated by the SEC provided they conform to specific rules. Due to the excessive amounts of risk taken by hedge fund managers, hedge funds are generally only open to the very wealthy and professional investors.

RETIREMENT TAX SHELTERS

Traditional IRA (Individual Retirement Account): A tax-deferred retirement account for an individual, open to withdrawal at the age of 59.5. Many suggest that individuals who expect their tax rate to be lower in the future should opt for the Traditional IRA over the Roth IRA. The reasoning behind this is quite simple; given the option of being taxed at a two separate rates, choose the lower one. The primary advantage of a Traditional IRA is that taxes are deferred on an individual’s contribution and earnings until the individual withdraws from the account. Deferred taxes mean the individual is not taxed on the money he or she contributes to the account until it is taken out. When the individual withdraws money from the IRA, it is then taxed as regular income. If an employee withdraws from the IRA prior to age 59.5, he or she will generally incur a 10% penalty. The 2008 maximum contribution limit (for both Traditional and Roth IRAs combined) is $5,000 for those under the age of 50 and $6,000 for those over 60.

Roth IRA (Individual Retirement Account): A retirement account for an individual in which he or she contributes after-tax money and, as a result, withdraws money tax-free after the age of 59.5. Many suggest that individuals who expect their tax rate to be higher in the future should opt for the Roth IRA over the Traditional IRA. The reasoning behind this is quite simple; given the option of being taxed at a two separate rates, choose the lower one. If an individual withdraws from the IRA prior to age 59.5, he or she will generally incur a 10% penalty. The 2008 maximum contribution limit (for both Traditional and Roth IRAs combined) is $5,000 for those under the age of 50 and $6,000 for those over 60.

Traditional 401(k): A defined contribution plan offered by an employer to its employees, which allows the employee to invest tax-deferred income for retirement purposes. First established in 1980, the Traditional 401(k) is named after its section in the Internal Revenue Code. There are two primary advantages of a Traditional 401(k) account. First, employers will often match up to a certain percentage of an employee’s annual contribution. Second, taxes are deferred on an employee’s contribution and earnings until the employee withdraws from the account. Deferred taxes mean the employee is not taxed on the money he or she contributes to the account until it is taken out. When the employee withdraws money from the Traditional 401(k) account, it is then taxed as regular income. If an employee withdraws from the account prior to age 59.5, he or she will generally incur a 10% penalty. The maximum contribution limit (for both Traditional 401(k)s and Roth 401(k)s) in 2008 is $15,500 and it will be $16,500 in 2009.

Roth 401(k): A defined contribution plan offered by an employer to its employees, which allows the employee to invest after-tax income for retirement purposes. The Roth 401(k) is essentially a cross between a Traditional 401(k) and a Roth IRA. There are two primary advantages of a Roth 401(k) account. First, employers will often match up to a certain percentage of an employee’s annual contribution on a pre-tax basis. Second, an employee’s contribution is after-tax, meaning the money in the Roth 401(k) account will be tax-exempt upon withdrawal. If an employee withdraws from the account prior to age 59.5, he or she will generally incur a 10% penalty. The maximum contribution limit (for both Traditional 401(k)s and Roth 401(k)s) in 2008 is $15,500 and it will be $16,500 in 2009.

Traditional 403(b) and Roth 403(b): These plans are essentially the same as the 401(k)s listed above except they are available for public education organizations and some non-profit employers. 

* For a phenomenal comparison chart on these retirement tax shelters, click here.

HIGHER EDUCATION TAX SHELTER

529 Plan: A 529 Plan provides a tax advantage for those investing in future higher education. Named after its section in the Internal Revenue Code, the 529 Plan actually allows investors two options: savings and prepaid. Under the savings option, money can be invested in the market (similar to retirement funds). Therefore, performance is based on the performance of selected funds. With the prepaid option, tuition credits can be purchased at today’s rates for use in the future. Therefore, performance is relative to the inflation of tuition prices. The primary advantage of the 529 Plan is that earnings are tax-exempt upon withdrawal, provided the 529 Plan is used for tuition, fees, textbooks, etc. at almost any recognized higher education institution. 529 Plans are sponsored by states or educational institutions and controlled by the donor.

* For more information regarding 529 Plans, click here.