Our glossary presents basic definitions of certain important financial terms and concepts. It does not describe all of the technicalities and complexities of these terms. In particular, retirement accounts are subject to truckloads of regulations whose impenetrability does much to keep tax accountants and other financial professionals in business.
Click on the term below, and you'll be taken to the discussion of that term.
Certificate of Deposit (or CD)
401(k) Account. The 401(k) account and its clones, the Thrift Savings account for federal civilian and military personnel, and 403(b) and 457 accounts for public sector and educational system personnel, are employer-sponsored retirement accounts that offer two advantages. First, the salary you contribute to them, along with investment gains, are not taxed until you withdraw them. That means your contributions can accumulate and produce compounded profits for decades, potentially, before you have to pay taxes on them. This delayed taxation supercharges the compounding effect you get from your investments. Second, many employers “match” at least some of your contributions. For example, an employee may receive a match from an employer for the first 3% of his or her salary contributed to the 401(k) account. That’s an instant 100% return on the initial 3% the employee contributes without any risk. Then, the employee might be allowed to contribute more without any additional match. If the employee adds another 7%, he or she will have an amount equal to 13% of his or her salary simply by saving 10% of his or her salary. It’s one of the best deals in town, and if your employer offers a retirement plan with matching funds, open an account. Even if the employer doesn’t offer a match, open an account because you’ll get to save and invest your money on a tax deferred basis. For those who are 50 or older, you can make additional contributions to 401(k) accounts--as much $5,000 more in 2007. Do this, if at all possible. The 401(k) account is the best legal tax shelter available to most Americans. We discuss 401(k) accounts in our section on retirement accounts.
529 Plan. A 529 Plan is a way to save for college expenses on a tax-advantaged basis. Almost all 529 plans are sponsored by a state. There are two types of 529 plans: the 529 savings plan and the 529 prepaid tuition plan. They are defined below and discussed at greater length in our discussion of saving for college.
A 529 Savings Plan account allows you to save after-tax dollars for college education expenses in an investment account without paying ongoing income taxes on the interest, dividends and other investment gains. Thus, the account grows on a tax-free basis. Some states even allow you to deduct at least some contributions on state tax returns (there is no federal deduction). If you use the money in a 529 Plan to pay for the tuition, room, board or other educational expenses of a child or other beneficiary of the plan, there is no income tax on the withdrawals. (Withdrawals for other purposes are subject to state and federal income tax, plus a 10% penalty; there are limited exceptions to the 10% penalty.) You, the donor, retain control of the money. That means the kid can’t take control of the account at age 18 and buy a sports car. Your 529 Plan account is not counted as an asset of the child for financial aid purposes, which may be advantageous. The money in the plan can be used at any accredited university or college; it’s not limited to just the public university of the state sponsoring the plan. You have to invest the money in the Plan in a limited number of options specified by the particular Plan you select, so make sure you like the options offered (and make sure they have low costs and fees).
The second type of 529 Plan is the Prepaid Plan. This type of plan allows you to pay today for your child’s college tuition in a public college or university of the state sponsoring the plan, with the sponsoring state’s guarantee that the tuition costs will be covered whenever your child enrolls. (However, some states do not literally guarantee coverage—read the fine print of each plan because some plans only say that the state legislature will consider covering shortfalls and a few prepaid plans don’t offer any guarantee at all.) Perhaps one 529 prepaid plan (Florida’s) also covers room and board, but most do not. This means that you still have to do some saving for those expenses even if you prepay the tuition. You or your child must usually be a resident of the state where the plan is located if you want to participate in the prepaid plan. There is also a prepaid tuition plan for a number of private colleges, the Independent 529 Prepaid Tuition Plan. This is for people who think their children will go to one of the 250 or so private institutions participating in this plan. Many of these schools are among the top colleges in the nation; but many other top colleges do not participate in this plan. This plan is expensive compared to prepaid plans for state institutions, because private colleges tend to be much more expensive that state schools.
After-tax dollars are the money from your salary and other income remaining after you have paid federal and state income taxes (and Social Security and Medicare taxes, in the case of earned income). Some investments we discuss, such as Roth accounts and the 529 Plans and Coverdell accounts for educational expenses, must be funded with after-tax dollars (and Roth accounts must be funded with aftertax earned income). That makes the initial investment in these accounts more expensive. But their earnings compound without ongoing taxation, which allows for faster growth, and those earnings will not be taxed when you use them, if you comply with the conditions of the accounts. Roth accounts are discussed in greater detail below and in our section on retirement accounts. 529 Plans and Coverdell accounts are discussed in greater detail below and in our section on saving for college expenses.
Annuity is a term for a wide variety of insurance products that are used for investment purposes. Some annuities are investments that pay you a regular income (such as immediate fixed annuities), while many other annuities are a form of tax shelter (such as the seemingly endless and complex array of deferred annuities). Annuities are controversial because many of them have high fees and expenses, and you can have a hard time figuring out how expensive they really are. Ordinary investors should not buy annuities, except possibly for lump sum immediate fixed annuities (which pay a fixed amount per month) or lump sum immediate inflation adjusted annuities (which pay you a monthly payment that is adjusted for inflation). We discuss annuities in our section about making retirement money last.
Bond: a financial vehicle used by governments and corporations to borrow money. A bond is a promise to repay the borrowed money at a specific date in the future (ranging from a year to 30 or more years). Bonds have either a fixed interest rate or an adjustable interest rate. Bonds, especially those with a fixed interest rate, can fluctuate in value depending on the general direction of interest rates. If interest rates rise, bonds tend to fall in value. If interest rates fall, bonds tend to rise in value. While this may seem counterintuitive, it makes sense when you think about it. A bond having a face amount of $100 which is due in 10 years, and which pays $5 a year in interest, has an interest rate of 5%. If interest rates change and new comparable 10-year bonds begin to pay 6% interest per year, the old 5% bond is less valuable because it pays a lower interest rate than new bonds. The reverse would happen if interest rates fell to 4% per year for comparable 10-year bonds. Then, the old 5% bond would rise in value because it pays a higher rate than new bonds. These fluctuations in bond values can create some unexpected rises and falls in the value of your bond investments; but bonds generally fluctuate in value less than stocks. We discuss bonds in our section on managing investment risk.
Capital gains are increases in the value of an investment. For example, if you buy a stock at $20 a share and it increases to $25 a share, you will have a capital gain of $5. If you sell the stock, you will have a realized capital gain of $5 per share. Long term capital gains (i.e., gains from assets that you hold for more than a year before selling) are generally taxed at lower rates than short term capital gains (which are taxed as ordinary income).
Cash flow is the money you have coming in the door, and is essential to life in a modern economy. You should understand that your lifetime earnings consist of a flow of cash that stops when you stop working, and you must replace it with other sources of cash. Social Security and a pension, if you have one, are sources of retirement cash flow. For most people, other sources of retirement cash flow are their savings and investments.
Certificate of Deposit (or CD). The CD, as we use the term, has nothing to do with data storage or music. It is a type of bank account, in which the customer deposits money for a stated period of time, which can be anywhere from a month to a number of years, at an interest rate that usually is fixed at the time the CD is opened. Occasionally banks offer CD’s with adjustable interest rates. But the large majority of CD’s have fixed interest rates. The advantage of the fixed rate is that you know what you’ll get. You may end up unhappy if interest rates rise during the term of the CD. But you’ll feel like the cat that ate the canary if interest rates drop.
Compounding is the way that money grows when it is invested and its earnings are reinvested. Compounding has a powerful effect when money is invested and reinvested for long periods of time, and is one of your most important allies in the struggle to fund your retirement. For example, assume you invest $10,000 in a mutual fund that earns an average of 7% per year for the next 30 years. That means it generates $700 of gains, on average, each year. You can either withdraw the gains, and spend them on pretzels and beer; or you can reinvest them, which simply consists of leaving them in the mutual fund so that they themselves generate additional gains. If you take the $700 in annual gains out of the mutual fund each year, you’ll have only your original $10,000 at the end of 30 years. Assuming the long term historical rate of inflation of 3%, this amount, adjusted for inflation, would be worth around $4,000 in today’s dollars. If you reinvest the $700 each year, you’ll increase both your principal and gains over time. At the end of the first year, you’ll have a new, improved principal of $10,700. That will produce 7% in gains on the combined total of $10,700 in the second year (or $749). The increased gains of the second year are added to the principal, resulting in an even larger principal at the end of year 2 of $11,449. That in turn will generate even more gains in year 3--$801.43--giving you a greater balance of $12,250.43. At the end of 30 years of such compounding, the value of the investment will be $53,860, assuming you are in the 25% federal income tax bracket (assuming a mix of long term capital gains rates and ordinary income rates), and have a 5.5% state income tax. Adjusted for inflation at a rate of 3% a year, you’ll have about the equivalent of $21,600 in today’s dollars. Thus, the effect of compounding, even after taxes and inflation, is to greatly magnify the value of your investment. In this example, it more than quintupled in inflation-adjusted, after tax terms. When saving for retirement or college expenses, always reinvest gains and earnings from your investments. If you love compounding, compounding will love you.
The corporation is a business organization. It sells pieces of itself, called “stock,” in order to raise money to conduct business. (In other words, it takes money to make money, for corporations as well as people.) People who buy stock become owners (collectively with all the other stockholders) of the corporation. Most stock gives its holders the right to vote for the election of directors and on other corporate matters. A few kinds of stock do not provide voting rights, or provide limited voting rights (corporate insiders hold most of the voting power in these circumstances). Stock can be purchased directly from a corporation. But usually you have to buy shares in the stock markets from other shareholders, because corporations generally sell shares at only select times.
Coverdell ESA. A Coverdell Educational Savings Account is a tax-advantaged savings account for educational expenses. Like a 529 Plan, you contribute after-tax dollars to the Coverdell account and its interest, dividends and other investment gains compound tax free. The Coverdell is much more flexible than a 529 Plan. It can be opened with a mutual fund management firm, a brokerage firm or other financial institution. The potential range of investments for a Coverdell includes almost anything under the sun except for insurance products. This will make it easier to find low cost investment choices. The earnings of the Coverdell are not taxed if used for educational purposes. They can be used for private elementary and high school expenses, as well as college costs. The disadvantages of the Coverdell are, first, they are available only to persons whose income does not exceed certain limits: $110,000 for singles and $220,000 for married couples filing jointly. The maximum contribution permitted is $2,000 a year, and this amount gradually diminishes for single taxpayers whose income is between $95,000 and $110,000, and married couples filing jointly between $190,000 and $220,000. The money in the Coverdell, unlike the 529, ultimately goes to the child who is the beneficiary if it is not used to finance education (after federal and state income taxes are paid, along with a 10% penalty). You cannot retrieve it for yourself. However, for financial aid purposes, it is treated as an asset of the parent, not the child, which may be an advantage. Coverdell accounts are discussed in greater detail in our section on saving for college expenses.
Credit unions are a kind of financial institution that function similarly to banks. They take deposits, pay interest, offer checking, savings and money market accounts, and certificates of deposit. Unlike banks, however, they are legally owned by their depositors and borrowers. They operate as nonprofit institutions, and therefore tend to offer higher interest rates on deposits, and lower interest rates on loans, than most banks. The higher interest rates on deposits are why you, a builder of retirement wealth, should consider joining a credit union. For arcane legal reasons, you can’t just walk into a credit union and open an account. You have to be able prove that you have a prescribed connection to the credit union. The connection can be through your employer, a family member who already has an account there, or sometimes a geographic connection. If you want to find out if you are eligible to join a credit union, go to http://www.creditunion.coop/how_to_join.html.
Diversification for financial planning purposes means that you should not put all of your eggs in one basket. To diversify your investments, put some money in each of at least several categories of assets. These might typically include stocks, bonds, cash and for most people, owning a house. Diversification reduces the chances of catastrophic loss of your wealth. Markets fluctuate up and down. Stock market investors didn’t believe that in the late 1990’s, but they found out in 2000 that they were mistaken. Real estate investors similarly learned in the mid-2000’s that markets can indeed drop in price. Believe it—markets fluctuate up and down, and if you diversify, you may lose money in some investments but will often hold steady or enjoy gains in other investments. It’s also true that diversifying limits your gains on a short term basis—if you put 100% of your savings into stocks during an upbeat time for the stock markets, you’ll make more than you would have if you put 65% of your assets into the stock markets and the rest in other investments. But no one can predict market movements with certainty, and if all your wealth is in stocks, you may unexpectedly suffer losses when the stock market declines (which will surely happen some of the time). Diversification is discussed further in our section on managing investment risks.
Dividends are payments made by companies to their stockholders. Dividends are usually cash payments made from the company’s earnings, and are part of the return to the stockholder for investing in the company’s stock. When you are saving for retirement or college expenses, you should always reinvest dividends, either in more of the company’s stock or in other investments. Don’t spend them. Reinvested dividends increase the compounding effect you get from your savings. Certain dividends, called “qualified dividends,” are taxed at lower rates than non-qualified dividends (which are treated as ordinary income).
Exchange Traded Fund (ETF). An exchange traded fund (ETF) is a special kind of mutual fund that can be bought or sold during the hours the stock market is open, at a price that normally reflects the most recent prices for its holdings of stocks and/or bonds. ETFs are bought or sold through stockbrokers. ETFs tend to have low management costs and expenses, but you also have to factor in the costs of commissions and other fees charged when you buy them. A very low cost traditional mutual fund can be less expensive for an individual investor, but ETFs will often be lower cost than actively managed traditional mutual funds. ETFs tend to be tax efficient (when they are based on a stock index).
Individual Retirement Account--Traditional (IRA). The traditional IRA is an account that has special tax advantages. Contributions you make to a traditional IRA are deductible on your tax return, and the earnings and profits of the investments in the account will not be subject to income tax until they are withdrawn. The account holder may contribute as much as $4,000 to an IRA in 2007 (and up to $5,000 if the account holder is 50 or over). Although IRAs started off years ago as a simple concept, they now have evolved a rather complex set of rules that limits their usefulness. For example, the $4,000/$5,000 a year limit applies to combined total of an individual’s contributions to his or her traditional and Roth IRAs (see below in this Glossary for a discussion of Roth accounts). So if the account holder contributes $2,500 to a Roth IRA, he or she can contribute only $1,500 to a traditional IRA (or $2,500 for a person who is 50 or older). The deductibility of contributions to a traditional IRA has become needlessly complex, and requires pages of discussion in the IRS’s Publication 590 (take a look at www.irs.gov/publications/p590/ch01.html#d0e1703 if you’re having a spasm of masochism). If you have no other retirement accounts, an IRA is better than nothing and you should have one. But if you (or your spouse) have other retirement accounts, your ability to deduct IRA contributions may be quite limited or non-existent. Think instead of having a Roth IRA, if your income level is low enough (see below). Its contributions are not deductible, but if you hold it for at least five years, you can later withdraw the earnings tax free; you don’t get tax free withdrawals from a traditional IRA funded with non-deductible contributions. IRAs are discussed further in our section on retirement accounts.
Money market account. This is a type of account offered by banks and credit unions. It will pay an adjustable interest rate. You will be allowed to make a limited number of withdrawals per month by check or otherwise, but the funds are otherwise accessible without penalty. The interest rates offered by bank money market accounts tend to be less competitive than rates offered by credit union money market accounts or money market funds (see below), although a few online banks sometimes offer competitive interest rates. Accounts at banks and credit unions are federally insured up to $100,000 per customer per institution (with money in retirement accounts insured up to $250,000 per customer per institution).
Money market fund. A money market fund is a kind of mutual fund that is similar to an interest bearing checking account at a bank. In general you can have immediate access to money you’ve invested in a money market fund; most of them allow you to write a check on the fund in the same way you would with a checking account. Money market funds tend to pay interest rates that are competitive. They generally have higher interest rates than interest bearing checking accounts or most bank money market accounts. Money market funds are not insured by any government agency. However, money market funds are usually invested in assets that tend to be pretty safe. The safest money market funds are those that invest only in U.S. Treasury securities. Since the U.S. government stands 100% behind U.S. Treasury securities, the money market funds that invest in them are essentially as safe as an FDIC insured bank or credit union account.
Municipal Bonds. Municipal bonds are bonds issued by a city or other public organization authorized by a state to borrow money by issuing bonds. Municipal bonds are generally exempt from federal income taxation, and are usually exempt from state taxation if they are issued by a municipality in the state where you live. The interest rates they pay are quire low; but that is because the bonds are generally tax exempt. Municipal bonds can be a fairly complex investment for the beginning investor. The interest on some muni bonds may be subject to the alternative minimum tax (please repeat after me: “we hate the alternative minimum tax”). Capital gains on municipal bonds are taxable by the federal and state governments. There are credit risks associated with municipal bonds. Some are backed by the full faith and credit of a state (meaning they are more likely to be repaid). Others, such as “revenue bonds,” are not backed by the state and may have a significant risk of default. Muni bonds can be sometimes “illiquid,” meaning they can be difficult to sell for a favorable price if you decide you don’t want to own it any longer. A wealthy person or couple may benefit quite a lot from investing in municipal bonds because the tax sheltering benefit is greatest for those in the highest income tax brackets (who, believe it or not, may actually be less exposed to the alternative minimum tax problem than middle and upper middle income taxpayers). But the ordinary investor probably should stay away from municipal bonds. Retirement accounts provide an easier tax shelter for the ordinary investor.
Mutual Fund. A mutual fund is an investment vehicle that holds financial assets such as the stocks, bonds, and perhaps a few other kinds of assets. Mutual funds sell shares of their stock to investors, who then indirectly own the underlying investments of the mutual fund. The purpose of a mutual fund is to allow its shareholders to participate in a mix of investments without having to buy all those investments individually. Mutual funds are a very important way for ordinary investors to have a diversified investment portfolio and are discussed at greater length in our section on managing investment risks.
Most mutual fund shares are bought or sold at prices based on the values of their holdings of stocks and/or bonds at the close of the financial markets for the day. You usually buy or sell mutual fund shares by directly contacting the company that manages the fund.
Mutual funds can be index funds or actively managed funds. Index funds invest in a way that copies, or mimics, a financial market index, like the Standard & Poor’s 500 or the Nasdaq 100. Index funds have low costs and fees because they don’t have to pay professional money managers to strategize for them. Actively managed funds hire professional money managers to select stocks and/or bonds for them to invest in. These funds have higher costs and fees, because the professionals have to be paid to do the investment strategizing. Some actively managed funds are quite successful. But most do no better, or even worse, than index funds. An investor who is just starting out has relatively little, or nothing, to gain by investing in an actively managed mutual fund,
Ordinary income is an income tax concept. It refers to income that is taxed at the general rates prescribed by the Internal Revenue Code. Basically, it means all income that doesn’t get any special treatment in the tax code. Typical forms of ordinary income are earned income like salaries, bonuses, commissions and net profits from a business (for personally owned businesses like sole proprietorships, Subchapter S corporations, and partnerships). Also, interest, dividends from money market funds and short term capital gains are ordinary income. Certain kinds of income, such as long term capital gains income and so-called “qualified dividends,” are exempted from taxation at ordinary income rates and are taxed at lower rates. Other kinds of income, such as interest on municipal bonds, are usually not taxed at all.
Pre-tax dollars are your salary and other earned income before you’ve paid federal and state income taxes. Certain savings vehicles we discuss, such as traditional 401(k) accounts and traditional IRA accounts, are funded with pretax dollars. Using pretax dollars to save for your retirement appears, at first glance, to be an inexpensive way to save. However, with the availability of Roth IRA and 401(k) accounts, which are funded with after-tax dollars but allow for tax-free withdrawals if you meet certain conditions, it’s less clear that saving with pre-tax dollars is always best strategy.
Principal is the original amount you pay for an investment. For example, if you deposit $10,000 in a bank certificate of deposit, that initial $10,000 is the principal. The interest that the bank pays is not part of the principal, unless the interest remains in the account and is compounded (i.e., begins to bear interest itself.)
The term “principal” can also apply to your debts. In that sense, it refers to the amount of money that the bank or other lender provides to you. Interest is charged on the principal amount. In order to pay off the debt, you have to repay the principal as well as pay the interest. The principal continues to accrue interest charges as long as it is outstanding, so paying down the principal is the way to eliminate the debt.
There are certain mortgages, generally known as “option ARMs,” which give you the option of not paying the full amount of the interest that accrues every month. Any unpaid portion of the interest is added to the principal of the debt, in effect increasing the principal, and accrues interest along with the original principal. This feature, called “negative amortization,” both increases the amount of your debt and the amount of interest that the debt accrues every month. After a relatively short period of time, usually not more than a few years, the borrower is expected to start paying down the principal (including negatively amortized amounts that increased the principal) as well as all of the interest. That could result in a sizeable increase in the monthly payment. Option ARMs are ill-suited for ordinary investors. The option ARM is marketed as a convenient way to qualify for a mortgage, but requires the borrower to take on a lot of risk. The borrower faces the risk that interest rates will rise, which is something that many borrowers have discovered is a real risk. Even if interest rates don’t rise, the monthly payments will increase within a few years to begin the process of paying down the principal, and the borrower must have enough income or other resources to make those payments. If the borrower can’t make the increased payments, he or she would have to either refinance the loan or sell the house. Both alternatives could be difficult in a falling real estate market, which is a reality in many places. A fixed rate 15 or 30 year mortgage is the way to go for most borrowers. We discuss the problem of financing real estate further in our section on real estate.
Roth 401(k) account. Some employers may offer Roth 401(k) accounts. These accounts are funded with the employee’s after-tax income. You get no deduction from contributing to them. But the earnings in these accounts are not taxed immediately, and can eventually be distributed tax free (basically, after you’ve held the account for at least 5 years and have attained the age of 59 ½). The conventional wisdom is that if you expect to be in a higher income tax bracket in retirement than while working, a Roth 401(k) may be sensible. But if you expect to be in a lower income tax bracket after retiring, a conventional 401(k) is said to be better. Whether these guidelines are correct may depend on the assumptions you make about future tax brackets, and how close you are to retirement age. The closer you are to retirement, the more likely a conventional 401(k) will make sense because middle aged people are likely to be in higher tax brackets and many people fall into a lower tax bracket after retiring. On the other hand, someone who is 30 years away from retiring may be better off with a Roth 401(k) because he or she is likely to be in the early stages of his or her career and therefore in a lower tax bracket. Unlike the Roth IRA, the Roth 401(k) is available to anyone, regardless of his or her income level. So higher income persons can have Roth 401(k) accounts, if they wish.
If your employer makes a matching contribution, the portion that matches your Roth 401(k) contributions will be kept in a separate pretax account. Withdrawals from that account would be subject to taxation as ordinary income.
Roth 401(k) accounts are discussed further in our section on retirement accounts.
Roth IRA. A Roth IRA is a retirement account that you fund with after-tax dollars. In other words, you don’t get a deduction for the contributions you make to a Roth IRA. However, if you hold the Roth IRAfor at least five years, you will be able to withdraw the earnings in the account tax free once you reach the age of 59 ½ (the contributions can be withdrawn tax free, as well, because they’ve already been taxed). You can contribute up to $4,000 to a Roth IRA (or $5,000 if you are 50 or older). However, eligibility for Roth IRAs is limited to persons whose incomes don’t exceed certain levels ($160,000 for married couples filing jointly and $110,000 for singles). To make things worse, the amount you can contribute begins to shrink at lower income levels ($150,000 for married couples filing jointly and $95,000 for singles). To get a headache learning more about Roth IRA contribution limits, go to www.irs.gov/publications/p590/ch02.html#d0e8975.
Roth IRA accounts are discussed further in our section on retirement accounts.
SEP IRA. The SEP IRA is a retirement account for self-employed individuals and small businesses. Self-employed individuals may contribute approximately 18.5% of the net income from their business in the account, up to a limit that is adjusted for inflation each year (the limit in 2007 is $45,000). Although the literature you may read about SEP IRA’s suggests that you can contribute 20% of your net income, that’s only true after you reduce your net income by the amount of the deduction you can take for half of your Social Security taxes (if you’re not self-employed, don’t try to understand this stuff unless you want the mother of all headaches; if you’re self-employed, be prepared for the mother of all headaches). A small business that has employees and a SEP-IRA may contribute as much as 25% of their annual compensation to the SEP-IRA account for each employee up to the annual limit ($45,000 in 2007). Employees themselves do not make contributions to their SEP-IRA accounts.
A SEP-IRA is a good plan for a self-employed person who is earning a substantial income (up to around $225,000 a year). If you’re consistently exceeding that income level, you may wish to consult with a tax accountant about what retirement options you have (there are alternatives, but they don’t apply to the ordinary investors at whom we are focused). SEP-IRAs are somewhat complex, but financial institutions and mutual fund managers have employees who can assist you. If you have no employees, a SEP-IRA is relatively simple once you get the hang of figuring out how much you can contribute.
SIMPLE IRA. The SIMPLE IRA is another small business retirement plan for self-employed individuals, and their employees (if they have any). A SIMPLE IRA could be described as a mini-401(k) type plan, where employees choose to make contributions that are deducted on a pre-tax basis from their salaries, and the employer matches their contributions up to a specified percentage of their salaries. The maximum amount a person can contribute to a SIMPLE IRA is $10,500 per year. Account holders who are 50 or over can make additional contributions (up to $2,500, subject to certain limitations). The employer can, instead of matching employee contributions, make “non-elective” contributions for each employee, which are contributions that the employer makes to each employee’s account regardless of whether or not the employee chooses to contribute any portion of his or her salary to the SIMPLE IRA. Contrary to their name, these accounts are not very simple, and their low contribution limits make them less desirable for self-employed persons who are doing well. A SIMPLE IRA is useful for self-employed persons who make relatively modest incomes (about $55,000 or under) and want an account that allows them to contribute a greater portion of their income than the 18.5% or so allowed by a SEP-IRA. Financial institutions and mutual fund managers have staff to help you with setting up a SIMPLE IRA, if that appears to be best for you.
Stock is a form of ownership of corporations. A corporation is an organization collectively owned by people who invest in it by purchasing its stock. A share of a corporation’s stock confers ownership of a tiny fractional portion of the corporation. As the owners, stockholders benefit from growth in the corporation’s business and profits, which tend to push the price of the stock up. But they also can sustain losses if the corporation does poorly and the price of the stock drops. If the company goes into bankruptcy, creditors of the corporation (such as the bond holders, and also banks that lend money to the corporation) get paid out ahead of the stockholders. But if a company does well, the gains enjoyed by the shareholders are likely to exceed the gains enjoyed by bondholders and general creditors.
Stockbrokers are people and firms that serve as intermediaries in the process of buying and selling stocks. You can’t personally call or e-mail a stock market to buy or sell. You have to go through a stockbroker. (However, you can directly invest in or sell mutual funds—except ETFs--by contacting the company that manages the fund.) Stockbrokers charge commissions and/or other fees for their services.
Tax efficiency means that an investment, usually a mutual fund, is managed to minimize the taxes that investors must pay on an ongoing basis before they sell their holdings. Investors in mutual funds are legally required to pay income taxes on the current income of the fund, even if they do not receive that income. To minimize this expense, some mutual funds try to limit the extent they generate income that is currently taxable to their investors. One means is to limit the amount of short term buying and selling of investments they do. Ordinary investors looking for long term investments in taxable accounts should consider tax efficiency as well as other factors. Broadly based index funds, such as those based on the S&P 500, tend to be tax efficient. ETFs (or exchange traded funds) are also tax efficient, although they may have other features that are less attractive to ordinary investors (see the discussion of ETFs at the end of our section on managing investment risk.) Tax efficiency is not an issue for tax sheltered accounts like 401(k)s and IRAs, since investors need not pay taxes on the earnings of those accounts until they make withdrawals.
Taxable account is the ordinary kind of bank, credit union, mutual fund, or stock brokerage account in which the interest, dividends, capital gains and other income is immediately subject to federal and state income taxes. All financial accounts are taxable, unless they have a special tax advantage (like IRAs, 401(k)s, SEP-IRAs, etc.).