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College Students and Recent Grads, Featured, Investing, News, Retirement

Where the Wealthiest Millennials Stash Their Money

Editorial Note: The editorial content on this page is not provided or commissioned by any financial institution. Any opinions, analyses, reviews or recommendations expressed in this article are those of the author’s alone, and may not have been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

There’s been much talk about millennials being fearful of the stock market. They did, after all, live through the financial crisis, and many are shouldering record levels of student loan debt, while grappling with rising fixed costs.

The truth is that historically, young people have always shied away from investing. A whopping 89% of 25- to 35 year-old heads of household surveyed by the Federal Reserve in 2016 said their families were not invested in stocks. That’s only two percentage points higher than the average response since the Fed began the survey in 1989.

MagnifyMoney analyzed data from the 2016 Survey of Consumer Finances, conducted by the Federal Reserve, to determine exactly how older millennials — those aged 25 to 35 — are allocating their assets.

In 2016, wealthy millennial households, on average, owned assets totaling more than $1.5 million. That is nearly nine times the assets of the average family in the same age group — $176,400. Included were financial assets (cash, retirement accounts, stocks, bonds, checking and savings deposits), as well as nonfinancial ones (real estate, businesses and cars).

While the wealth of each group was spread across just about every type of asset, the biggest difference was in the proportions for each category.

To add an extra layer of insight, we compared the savings habits of the average millennial household to millennial households in the top 25% of net worth. We also took a look at how the average young adult manages his or her assets to see how they differ in their approach.

Millennials and the stock market

Despite significant differences in income, we found that both sets of older millennial households today (average earners and the top 25% of earners) are investing roughly the same share of their financial assets in the market – about 60%.

Among the top 25% of millennial households, those with brokerage accounts hold more than 37% of their liquid assets, or about $224,000, in stocks and bonds and an additional 26%, or $154,000, in retirement accounts. Meanwhile, just over 14% of their assets are in liquid savings or checking accounts.

By comparison, the average millennial household with a brokerage account invests a little over $10,000 in stocks and bonds, or 22% of their total assets, and they reserve about 21% of their assets in checking or savings accounts.

Millennial households invest most heavily in their retirement accounts, accounting for around 38% of their financial assets, although they have only saved $18,800 on average.

Wealthy millennials carry much less of their wealth in checking and savings, compared with their peers. Although wealthier families carry eight times more in savings and checking than the average family — $84,000 vs. $10,300 — that’s just roughly 14% of their total assets in cash, while for the ordinary young family that figure is around 20%

The Fed data show that those on the top of the earnings pyramid are able to save far more for the future, even though they’re at a relatively early stage of their careers.

Across the board, older millennial families hold the greatest share of their financial assets in their retirement accounts. Although that share of retirement savings is smaller for wealthier millennial families (26% of their financial assets, versus 38% for the average older millennial family), they have saved far more.

When looking at the median amount of retirement savings versus the average, a more disturbing picture emerges, showing just how little the average older millennial family is saving for eventual retirement.

The median amount of money in higher earners’ retirement account is $90,000 (median being the middle point of a number set, with half the available figures above it and half below). But the median amount is $0 for the typical millennial family, meaning that at least half of millennial-run households don’t have any retirement savings at all.

Millennials and their nonfinancial assets

Most of millennial households’ wealth comes from physical assets, such as houses, cars and businesses.

While nearly 60% of young families don’t own houses today, the lowest homeownership rate since 1989, homes make up the largest share of the family’s nonfinancial assets, Fed data show.

For the average-earning older millennial family, housing represents more than two-thirds of the value of its nonfinancial assets — 66.4%. On average, this group’s homes are valued at $84,000.

The homes of rich millennial households are worth 4.6 times more, averaging $470,000 — though they represents a lower share of total nonfinancial assets — 50%.

Cars are the second-largest hard asset for the average young family to own, accounting for about 14% of nonfinancial assets.

While rich millennials drive fancier cars than their peers — prices are 2.4 times that of average millennials’ cars — their $42,000 car accounts for just 4.5% of their nonfinancial asset. In contrast, they stash as much as 31% of their asset in businesses, 20 percentage points higher than the ordinary millennial.

It’s worth noting that young adults in general are not into businesses. A scant 6.3% of young families have businesses, the lowest percentage since 1989, according to the Fed data. (Among those that do have them, the businesses represent just over 11% of their total nonfinancial assets.)

The student debt gap

Possibly the starkest example of how wealthy older millennials and their ordinary peers manage their finances can be seen in the realm of student loan debt.

A significant chunk of the average worker’s household debt comes in the form of student loans, making up close to 20% of total debt and averaging $16,000. In contrast, the wealthiest cohort carries about $2,000 less in student loan debt, on average, and this constitutes just about 4.6% of total debt.

With less student debt to worry about, it’s no surprise wealthier millennial families carry a larger share of mortgage debt. About 76% of their debt comes from their primary home, to the tune of $233,500, on average. This is 4.5 times the housing debt of a typical young homeowner.

In some cases, the top wealthy have another 11% or so of their total debt committed to a second house, something not many of their less-wealthy peers would have to worry about — affording even a first home is more of a struggle.

When is the right time to start investing?

For many millennials the answer isn’t whether or not it’s wise to save for retirement or invest for wealth but when to start. Generally, paying off high interest debts and building up a sufficient emergency fund should come first. Once those boxes are ticked, how much young workers invest depends on their tolerance for risk and their future financial goals.

“It’s never too much as long as you’ve got money for the emergency fund, and as long as they are funding their other goals not through debt,” says Krista Cavalieri, owner and senior advisor at Evolve Capital in Columbus, Ohio.

The biggest mistake that Cavalieri has seen among her young clients is that very few have been able to establish an emergency fund that will cover at least three to six months’ worth of living expenses.

Kelly Metzler, senior financial advisor at the New York-based Altfest Personal Wealth Management, said older millennials may not be able to save outside of retirement accounts yet, which can be a concern if they want to buy a house or have other large purchases or unexpected expenses ahead.

Cavalieri said that’s because young adults’ money is stretched thin by the varies needs in their lives and the lifestyle they keep.

“Their hands are kind of tied at where they are right now,” she said. “Everyone could clearly save more, but millennials are dealing with large amounts of debt. A lot of them are also dealing with the fact that the lack of financial education put that in that personal debt situation.”

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Shen Lu
Shen Lu |

Shen Lu is a writer at MagnifyMoney. You can email Shen Lu at shenlu@magnifymoney.com

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Investing

12b-1 Fees: Learn About These Costly Mutual Fund Charges

Editorial Note: The editorial content on this page is not provided or commissioned by any financial institution. Any opinions, analyses, reviews or recommendations expressed in this article are those of the author’s alone, and may not have been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

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When deciding how to invest your money, it’s important that you choose your portfolio carefully. Besides picking what kinds of stocks, exchange-traded funds (ETFs) and mutual funds to invest in, you also need to consider the fees the different options charge. While many investments have fees, they can vary a great deal. Choose the wrong one, and the fees could eat away at your returns.

One of the most common fees is the 12b-1 fee, but it’s a fee you’ll encounter only if you make certain types of investments. Below, find out how 12b-1 fees work, how they can affect your returns and how to avoid them.

What are 12b-1 fees?

When you have a limited amount of money to invest, opting for mutual funds over individual stocks can make a lot of sense. Mutual funds are investment vehicles that are made up of many individual stocks and bonds rather than just one.

Actively managed mutual funds employ a manager who oversees the fund, deciding which investments to buy, sell and hold. Mutual funds allow you to diversify your portfolio, giving you more protection than investing in just one or two companies.

While mutual funds can be a smart investment strategy, they often have fees you should know about. Managing a mutual fund has costs, including transaction fees and operational expenses. One of the more common fees is a distribution fee known as 12b-1.

A 12b-1 fee is paid by the fund — using fund assets — to cover the costs of marketing and selling the fund, shareholder services (such as answering investor inquiries) and sometimes even employee bonuses.

According to the Investment Company Institute, 12b-1 fees have been around since 1980, when the Securities and Exchange Commission (SEC) installed the fee as a way to help investors. The fee was instituted to market mutual funds and, in theory, to increase assets and potentially decrease expenses.

Funds that charge 12b-1 fees believe they help increase a fund’s value through marketing and building demand. However, whether that’s true is up for debate. Critics say 12b-1 fees do nothing to increase the value of a fund or boost its demand, making the fees feel like an unnecessary upcharge.

12b-1 fees: the cost to investors

12b-1 fees can vary a great deal from fund to fund, but the SEC has set caps on how much companies can charge. All told, the fee cannot exceed 1% of the fund’s average net assets.

  • Fees used to pay for marketing and distribution expenses cannot exceed 0.75% of the fund’s average net assets per year.
  • Fees used to cover shareholder services cannot exceed 0.25% of the fund’s average net assets per year.

According to Robert Schultz, a certified financial planner with NWF Advisory Group in Los Angeles, a 1% fee may sound small, but over time, it can significantly affect the growth of your investment.

“12b-1 fees come directly out of the returns,” Schultz said. “The higher the fee, the worse off the investor.”

For example, say you invested $100,000. Assuming a 4% annual return and a 1% annual 12b-1 fee, your investment would grow to $180,000 over the course of 20 years. Sounds great, right? Not so fast.

If your fee had been only 0.25%, your investment would be worth $210,000. The higher fee would cost you $30,000 in market growth.

To find out what 12b-1 fees your fund charges, Schultz recommended doing some homework. “Investors should review the prospectus,” he advised.

If you’re not sure where to find it, contact your broker or investment manager directly and ask for it. The prospectus is a legal document filed with the SEC that outlines the details of the mutual fund. There can be many different fees listed, including redemption fees, exchange fees, purchase fees and account fees.

How to avoid 12b-1 fees

While 12b-1 fees can eat into your returns, it’s important to know that not all mutual funds charge these fees. It’s possible to find mutual funds that don’t charge them at all.

“Not all mutual funds charge 12b-1 fees, and some that do credit it back to the client,” said Schultz.

A fee-based fund, which charges a flat fee for advice or management services, often will credit the fee back to the client since it already charged a fee. If you need minimal advice or management help, a fee-based investment may be a smart option for you.

Another option is to invest in ETFs or index funds that don’t require active management. That way, you can avoid 12b-1 fees altogether.

Bottom line

Some mutual funds charge 12b-1 fees. While they’re relatively low, they still can have a significant impact on your net returns. If you’re looking for your money to grow as much as possible, avoiding 12b-1 fees can improve your investment returns over time.

If you need help choosing an investment strategy, a financial planner can be a huge help. If you don’t know where to start, check out our guide on how to choose a financial planner.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Kathryn Tretina |

Kathryn Tretina is a writer at MagnifyMoney. You can email Kathryn here

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Investing

How to Invest in Penny Stocks

Editorial Note: The editorial content on this page is not provided or commissioned by any financial institution. Any opinions, analyses, reviews or recommendations expressed in this article are those of the author’s alone, and may not have been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

The opportunity to purchase stock with a minimal initial investment — or to be an early shareholder in a small company with potentially stratospheric growth — can make the idealistic allure of penny stocks hard to resist. Unfortunately, the reality is often much less glamorous.

Penny stocks can be extremely volatile, the underlying companies are often unproven and difficult to value, and they often trade so infrequently that shares can be difficult to sell. This makes penny stocks far more risky than the name implies. And that’s before you factor in the outright fraud that sometimes runs through the penny stock market.

Before you jump in, it’s important you understand exactly how to invest in penny stocks, how they work, and what to look out for if you do. Then strongly consider the risks involved to protect your pocket change from turning into significant losses.

What are penny stocks?

Penny stocks are equities that are low in price — although not necessarily as low as the name implies. The SEC defines a penny stock as trading for less than $5 per share, generally issued by small companies with market capitalizations of $300 million or less. Otherwise known as microcaps (or, if they are less than $50 million, nanocaps), these companies don’t tend to have the established track records or history of public information that more significant, publicly traded companies do, nor do they typically file annual financial statements and regulatory documents with the SEC. For these reasons, shareholders in penny stocks don’t always have the same visibility into the companies in which they invest.

Why the low share prices? Because they generally haven’t been good investments. These may be companies with failing business operations, excess debt or even allegations of fraud. And while it may seem more likely for a company’s share price to increase because it’s only $1, keep in mind that share prices are relative to the company’s value or growth.

How penny stocks are traded

Another thing that makes penny stocks different from other stock investments: they don’t generally trade on stock exchanges like the New York Stock Exchange (NYSE), Nasdaq, etc. Those large, central exchanges have minimum requirements for listing a stock, which penny stocks don’t tend to meet.

Instead, penny stocks often trade over-the-counter (OTC) through online marketplaces where dealers can price and quote securities not listed on a major exchange. Penny stocks are sometimes referred to as OTC stocks or OTC securities.

While there are undoubtedly some skilled traders or professional money managers using penny stock trading as an active investment strategy, the odds are not on the side of the average investor. In 2016, an analyst from the Securities Exchange Commission (SEC) looked at 1.8 million trades made by more than 200,000 individual investors and found that the typical OTC or penny stock investment return is severely negative. It showed that investors were twice as likely to lose money investing in penny stocks as they were to gain and that outcomes were worse when the penny stock was part of a promotion, or it was a less-regulated offering.

Explaining OTC Markets

Two of the most well-known over-the-counter markets are the OTC Bulletin Board and OTC Link Alternative Trading System (ATS). From the investor’s perspective, these trading platforms may not seem different from the NYSE or NASDAQ, but they aren’t the same large, closely watched markets. It’s important to understand which markets are regulated and how.

The OTC Bulletin Board, run by the Financial Industry Regulatory Authority (FINRA), is an online quoting platform for thousands of eligible OTC securities. Companies must meet specific requirements to be included, such as maintaining updated financial reports with the SEC and a getting a broker-dealer sponsorship.

The OTC Link is part of the OTC Markets Group, which is an extensive network of dealers providing online quotes for a broad array of exchange-listed and OTC equities, foreign equities and corporate debt. It does this within three marketplaces, each requiring different levels of filings and information from the companies trading on them.

  • QTCQB securities are filed with the SEC or a U.S. bank, thrift or insurance regulator. In other words, they are up-to-date in meeting specific requirements.
  • QTCQX securities are either filed with the SEC, U.S. bank, thrift or insurance regulator, or meet alternative requirements, including audited financial statements and a third-party bank or investment advisor to help them stay on top of financials.
  • OTC Pink (Pink Open Market) securities are everything else, which may include distressed companies, shell companies, foreign companies uninterested in filing domestically, etc. This is a market for companies that don’t want to file with the SEC.

OTC Link is a member of FINRA and registered with the SEC as a broker-dealer, as well as an alternative trading system.

Buying penny stocks

You can purchase penny stocks through brokers as you would any other type of security, through full-service brokers such as Fidelity and Charles Schwab, as well as online brokers E-Trade, Ally Investments and TD Ameritrade. All have either multiple or extensive trading platforms, reasonably low fees, and provide access to research and education materials.

If you are interested in working with an independent broker, FINRA’s BrokerCheck tool can help you find out if the firm or individual broker is registered.

What to look for in a penny stock

If you are going to purchase penny stocks, research counts; it is arguably more important in the penny stock market, where the companies are small and unfamiliar.

Here are a few key things to look for.

Access to company information

Some companies provide more public information than others, try to favor those that offer the most transparent access to information. Do your research to learn as much as you can about earnings, management, products and services, operations and competition. Analyst research reports are ideal, and a sign of a company worth following. Ask your broker or use their online tools for tracking down any additional information that is available.

You can also search the EDGAR company lookup tool on the SEC website to find the latest company financials. If a company hasn’t registered with the SEC, it might start by filing with state securities regulators in its headquartered state. You can check for those through the company’s Secretary of State or state securities regulator. Any red flags about the company — regulatory actions, past problems with investors, etc. — are likely to surface during this research.

Active trading volume

Trading volume is the number of shares of stock that trade each day. A stock with a higher average daily trading volume and an increasing price may indicate a lot of interest, and the lower the trading volume, the more difficult the stock may be to sell. Low trading volume is also a sign of low liquidity, meaning the stock price may see large swings when investors buy and sell the stock.

Warning signs

The OTC Markets will label certain stocks with a skull and crossbones and as “Caveat Emptor,” or buyer beware. This is to warn investors of shares that may be under suspicion of fraud, a public interest concern or another reason to exercise additional care.

What to avoid when trading penny stocks

You’ve heard of “big fish” stories? Get ready for “big penny” stories, sometimes in newsletters or promotions, sometimes even coming from company leadership.

Beware of claims touting unbelievable returns without risk, and watch out for some of these red flags that the SEC cautions investors about:

Promotions

When a penny stock investment is promoted heavily through spam email, online newsletters, press releases or cold calling by desperate brokers, it’s generally a sign of a “pump and dump.” That means someone is trying to push the price higher so they can sell shares short and make a lot of money. Even when promotions are not an act of fraud, wise investors should investigate before investing in stocks with wild claims of growth.

Insider ownership

If an individual or group within the company owns a majority of the shares, the stock is more at risk for manipulation. According to the SEC, company insiders holding large amounts of the capital can also be a sign of potential “pump and dump” schemes.

Suspensions

The SEC can temporarily suspend trading on the stocks of companies it believes are misleading investors. A stock with a track record of suspensions may be a bad sign.

Big assets, little revenue

Impressive asset numbers may be misleading if the company is including among its assets real estate or other factors not related to the business. Focus on the company’s revenue instead, which will be an important measure of growth.

Funky footnotes

According to the SEC, microcap fraud often involves strange loans or transactions involving people connected to the company. The footnotes are a great place to look for this type of activity. Additionally, if you’re looking through company financials, check to make sure the auditor has signed off. If not, it’s a red flag.

Bottom Line

Penny stocks can be a bit of a roller-coaster ride. The markets are rife with scams, the odds stacked against the average investor — and even if you do get lucky with penny stocks, the investments are generally too risky to build a stable, long-term portfolio.

If you’re still interested in investing in penny stocks, it may be best to get off to a small start and remember not to invest more than you can afford to lose. With a balanced portfolio earning average market returns, a small allocation of penny stocks shouldn’t break the bank.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Melissa Phipps
Melissa Phipps |

Melissa Phipps is a writer at MagnifyMoney. You can email Melissa here

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Investing

Smart Investment Choices for Your Roth IRA

Editorial Note: The editorial content on this page is not provided or commissioned by any financial institution. Any opinions, analyses, reviews or recommendations expressed in this article are those of the author’s alone, and may not have been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

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Roth IRAs are retirement savings vehicles that allow participants to make after-tax contributions (as opposed to pretax contributions to traditional IRAs). Account earnings then grow tax-deferred. If the account holder meets certain requirements, withdrawals after age 59 and a half are entirely tax-free, including earnings.

Roth IRA: contribution limits

For the 2019 tax year, investors can contribute a maximum of $6,000 to a Roth IRA. This is up $500 from the 2015-2018 contribution limit of $5,500. Taxpayers who are 50 years of age or older can contribute an additional $1,000 in catch-up contributions for both 2018 and 2019.

For 2019, Roth IRA contributions phase out at between $122,000 and $137,000 in income for single taxpayers and between $193,000 and $203,000 in combined income for married taxpayers.

Roth IRAs: a popular way to save for retirement

Roth IRAs remain a popular choice for retirement savings. According to a recent report by the Investment Company Institute (ICI), Americans held $810 billion in Roth IRAs at the end of 2017. Some 34% of IRA investors had a Roth IRA at year’s end in 2016 (the latest year available). The ICI found that 31% of Roth IRA investors are under the age of 40. That same report said stocks and stock mutual funds represent 65% of Roth IRA assets as of 2016. If you include the stock portion of so-called target-date mutual funds, that number increases to 78%.

Roth IRA tax benefits

As a Roth IRA investor, you can invest your account assets in virtually any available investment vehicle. This includes alternatives such as stocks, bonds, put and call options, mutual funds, bank deposits, and exchange traded funds (ETFs). However, because of the unique tax characteristics of Roth IRAs, conventional wisdom argues that some investments may offer more advantages than others.

As noted earlier, Roth IRA investors get no upfront tax break. But when you take distributions, all withdrawals (including earnings) are tax- free as long as you are at least 59 and a half and the account has been in existence for at least five years (as opposed to traditional IRAs, where all distributions are taxable, including earnings).

The unique tax treatment of Roth IRAs, where you pay no tax on distributions, suggests that you consider choosing investments that have the potential to pay high taxable income (and hopefully a higher yield) and concentrate on finding vehicles that offer those characteristics.

Smart investments for a Roth IRA

Here are three investment characteristics that may be well-suited to your Roth IRA:

  • They have high dividends, including real estate investment trusts (REITs), utility stocks and the stocks of companies. Of course, some mutual funds also hold these kinds of investments.
  • They are actively managed or traded, meaning there is high potential for taxable capital gains. This might include an actively managed mutual fund or a portfolio of stocks that you expect to trade regularly.
  • They offer the potential for high growth. Examples might include so-called small-cap stock mutual funds as well as international stock mutual funds that are known to have the potential to grow over the long term. “Small-cap” refers to companies with a small market capitalization. While many consider small-cap companies to have a high potential for growth, they also carry more risk and are more volatile than larger companies.

In contrast, putting investments such as bank deposits, money market funds or low-growth stock mutual funds that pay low dividends into a Roth IRA may not be the best idea because these investments grow slowly and won’t ultimately result in a particularly high tax bill. That means there are few advantages to putting them in a Roth IRA, where all investment income — including dividends and capital gains — ultimately will be tax-free.

Kenneth F. Robinson, a certified financial planner for Practical Financial Planning in Cleveland, takes a narrower view on the best Roth IRA investments. In his mind, a tax-focused approach to investing can make a difference. His first suggestion is that investors put “investments that will grow the most” in Roth IRAs. For Robinson, those include small-cap stock mutual funds as well as international stock mutual funds. Robinson explained how holdings in these two investment categories “have historically earned the most over time.”

Robinson emphasized that if stocks are investments for the long run, “you have to look at them in the long run.” Over a period of, say, 15 years, he said, small-cap and international stocks and mutual funds “typically come out at or near the top” in comparison to their peers in terms of performance. Overall, Robinson thinks investors should look for investments with the potential for the greatest long-term growth.

High-growth investments in a Roth IRA are particularly appropriate for younger investors. Someone who is, say, 35 years old, will have 30 years or more for their Roth IRA to grow. The growth period can be even longer, as Roth IRA owners aren’t required to take minimum distributions based on their life expectancy from their account beginning at age 70 and a half. As a result, the growth period could be 40 years or more, emphasizing the importance of selecting investments that have the greatest potential for long-term growth.

The bottom line

Investing in a Roth IRA can be a great way to accumulate tax-free retirement income. However, the key to that strategy is choosing investments for your Roth IRA that have the potential to grow significantly over time. Doing so will ensure that you take maximum advantage of the tax benefits Roth IRAs offer.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Peter Fleming |

Peter Fleming is a writer at MagnifyMoney. You can email Peter here

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Investing

Stock Trading vs. Investing: 2 Different Approaches to Growing Wealth

Editorial Note: The editorial content on this page is not provided or commissioned by any financial institution. Any opinions, analyses, reviews or recommendations expressed in this article are those of the author’s alone, and may not have been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

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Maybe you’ve been investing for a while and you’re ready to take the next step into day trading. Or maybe you’re still wondering what exactly “day trading” means — and whether you should be taking such risks in the first place.

Although both require investment accounts to get started, stock trading and long-term investing are two very different approaches to growing your nest egg. And depending on your specific financial goals, risk tolerance and stock market savvy, one strategy may make a lot more sense for you than the other.

Here’s a basic rundown of the differences between stock trading and investing to help you make a more informed decision about how, when and where to allocate your assets.

Stock trading vs. investing: at a glance

Stock trading is a short-term approach to the market that’s focused on earning substantial gains right now. However, it can be riskier and more expensive than long-term investing — traders can lose money quickly on the wrong buy and are subject to more trading fees and higher taxes on capital gains.

Long-term investing, also known as the buy-and-hold approach, is focused on long-term gains. Investors allocate their assets based on how they think securities will perform over several years or even decades, riding out market fluctuations to achieve substantial growth down the line.

 Stock tradingInvesting

The goal

High earnings in the shortest time possible

Modest to high returns over a longer period of time

Time commitment required

Frequent monitoring of your account and considerable time researching investments and vetting your next purchase

Infrequent monitoring of your account; check in on its performance a few times a year

Common risks

Immediate losses as well as trading fees and higher tax rates on short-term capital gains (taxed at regular income bracket)

Stock losses over time and lack of substantial gains

Possible benefits

High returns in a short period of time

Significant growth over time due to compound interest; relative stability (if properly allocated); long-term capital gains tax benefits (lower than income bracket)

What is stock trading?

Stock trading takes place in the short term, meaning assets are bought and sold quickly, sometimes in as little as a few minutes or hours. There are several different types of stock traders, and their strategies and time frames vary:

  • Scalp trading is super short-term investing; scalpers might hold their assets for just a few minutes or even seconds. The capital gains made on each trade are usually quite small, which scalpers compensate for by performing many trades per day to create profit.
  • Day trading is the approach you likely think of when you think of a stock trader. These investors start each trading day with cash in their accounts, purchase assets and sell them all before closing time — with the intention of having more cash at the end of the day than they started with.
  • Swing trading is the longest-term approach to stock trading, with assets being held for several days or weeks. These investors are hoping to cash in on market trends without having to keep their cash locked away for the long term.

Stock traders are interested in immediate gains, which means they’re generally not buying long-term securities like government bonds or target-date funds. Instead, they might invest in a particular company’s shares in anticipation of a big announcement or new product reveal or bank on fluctuating currency rates with foreign exchange, or forex, trading.

Stock traders generally set rules to help themselves decide when to buy and sell an asset, usually based on a growth percentage. The aim, of course, is to buy low and sell high.

However, because these short-term purchases don’t leave much margin for error or time for market recuperation, substantial losses are possible — and traders also have to pay brokerage fees on each transaction.

What’s more, short-term capital gains (those on assets held one year or less) are subject to higher income taxes than long-term capital gains; traders pay as much on those gains as they would on any other income — which means up to 37%. Gains on assets held longer than a year usually are taxed at a lower rate: no more than 15% for the majority of taxpayers, according to the IRS.

What is investing?

Long-term investing, wherein an asset is bought and held, is all about using the power of compound interest to create substantial growth over a longer period of time — at least a year or two but often several decades.

Instead of banking on short-term market volatility, these investors create a long-term plan and soften their risks by purchasing diverse assets, including multiple kinds of securities in their portfolios — often pre-diversified securities like mutual funds and exchange-traded funds.

Although this strategy sometimes is referred to as buy-and-hold investing, Malik S. Lee, founder of Felton & Peel Wealth Management in Atlanta, suggested a slightly different tack. “I’m a firm believer in the ‘buy-and-evaluate’ model,” he said, stressing the importance of monitoring market performance over time.

Lee said that the average investor probably should re-evaluate their portfolio at least once a year, ideally with the advice of a financial professional. But at the same time, it’s important to remember that this is a long-term strategy — you shouldn’t pull your money out over every little market dip.

“You don’t want to react to a headline risk,” he said, “but in certain situations, you do have to go in there and make a change.” For example, if new legislation is passed that changes the market dynamic or the economy experiences a serious unexpected shift, reallocation may be in your favor.

Stock trading vs. investing: which approach is right for you?

Stock trading requires a significant tolerance of risk and a thorough understanding of the market; traders need to be up to date on business trends and current events at a global level. Even with the best stock algorithms and analyses technology has to offer, stock trading is a risky adventure at best — and high taxes and trading fees can diminish overall earnings.

Long-term investing, on the other hand, is an important part of any saver’s overall financial strategy, particularly for funding retirement. The power of compound interest can turn even modest contributions into a substantial nest egg given enough time and patience. And the IRS has created a number of tax incentives for buy-and-hold investors, from specialized retirement account benefits to lower tax liability on long-term capital gains.

Of course, all investments involve risks, and only you can decide what’s best for your financial future. Just be sure you know what you’re getting into before you click the “buy” button.

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Jamie Cattanach
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Investing

What is a SEP IRA?

Editorial Note: The editorial content on this page is not provided or commissioned by any financial institution. Any opinions, analyses, reviews or recommendations expressed in this article are those of the author’s alone, and may not have been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

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If you’re a freelancer or you run your own business, odds are you’ve heard about SEP IRAs, which are individual retirement accounts for self-employed individuals and small-businesses owners. A simplified employee pension (SEP) IRA gives you the ability to save for retirement while lowering your taxable income.

According to a survey by small-business site Manta, of the 66% of small-business owners who have a retirement plan, about 1 in 10 have a SEP IRA. Experts predict contract and freelance workers will make up half the workforce within the next 10 years.

Who can get a SEP IRA?

If you have freelance income, are a sole proprietor, or own a business with one or more employees, you can open a SEP IRA. If you’re a business owner and you open a SEP for yourself, you must open a SEP for each eligible employee.

According to the IRS, an eligible employee is anyone who is at least 21 years old, has worked for the same employer for three of the previous five years, and has received at least $600 in compensation from that employer during the current year. Employers can offer accounts to employees who don’t meet all the criteria, but they can’t withhold an account from any employee who does meet the criteria.

If a business owner offers a SEP IRA to employees, all contributions are funded by the employer — not by the employees.

Employee SEP IRA contribution limits

You can save up to 25% of your gross annual salary if you’re self-employed. That typically comes out to about 20% of your adjusted net earnings from self-employment, up to a maximum of $56,000 in 2019 (or $55,000 in 2018). You can calculate your sole proprietor contribution here.

SEP IRA contribution limits may hamper how much you can save toward retirement compared to other types of accounts — but that depends on your income and how much you wish to save. In nearly all cases, you’ll be able to save more with a solo 401(k), but you’ll first need to understand if you can save more than the SEP will allow.

“If someone is self-employed, they could be limited in their SEP contribution,” said Ted Toal, a financial planner in Annapolis, Md. “If they want to save more but the SEP formula doesn’t allow them to, they should instead look to open a solo 401(k).”

Here’s how the plans compare for a 40-year-old sole proprietor:

Self-employed net profitMax you can save to a SEP IRAMax you can save to a SIMPLE IRAMax you can save to a solo 401(k)

$50,000

$9,294

$13,853

$27,794

$100,000

$18,587

$15,207

$37,087

$200,000

$37,872

$18,015

$55,000

$300,000

$55,000

$20,750

$55,000

Source: National Life Group

Employer SEP IRA contribution limits

If you are a business owner, you must save the same percentage of compensation to both your plan and your employees’ plans. Additionally, you must save the lesser of 25% of each worker’s compensation or $56,000 in 2019 (or $55,000 in 2018). When calculating your contribution limit, do not count any compensation over $280,000 for 2019 (or $275,000 in 2018) or your SEP contribution.

Although you must save the same percentage to each employee’s account, you may change the percentage from year to year. As an added bonus, employer contributions to employee SEP accounts are 100% deductible as a business expense.

SEP IRA tax and withdrawal rules

Like an employer-sponsored 401(k) plan, your contributions to a SEP IRA are pre-tax, lowering your taxable income for the year you contribute. Your money (hopefully) will grow over time in the SEP IRA, and when you’re ready to withdraw the money during retirement, you’ll be taxed on distributions (based on your tax bracket at the time of withdrawal).

If you withdraw any funds before the age of 59 and a half, you’ll pay a penalty on top of taxes for the withdrawal. Once you reach the age of 70 and a half, you must start taking distributions, even if you aren’t retired yet. “For an owner who is over 70 and a half but still working, they don’t avoid the required distribution in the SEP IRA,” said Toal. “You always have to take it once you’re over 70 and a half.”

How to open a SEP IRA

Opening a SEP IRA is fairly simple, and typically there are no fees to establish the account. Here’s what you should know about opening a SEP IRA:

  • You can open a SEP IRA at any point up to your tax-filing deadline for that tax year, including extensions. “You have until October of the following year if you file an extension,” said Toal.
  • Find a reputable provider to work with, such as a brokerage firm or mutual fund company. Some examples include Vanguard, Fidelity and TD Ameritrade.
  • Most providers have a website where you can quickly and conveniently fill out a quick online application.
  • Once your account is established and funded (which may take a couple of business days) it’s time to choose your investments. The right investment mix for you will depend on your age and risk tolerance. Consider a balanced fund or target-date retirement fund that will conservatively grow as you approach your retirement date.

Is a SEP IRA right for you?

A SEP IRA is one of the simplest retirement accounts for freelancers or business owners to open, and it may allow you to save enough to live comfortably during retirement. “It’s very easy to administer in comparison to employer sponsored plans like 401(k)s,” explained Darin Shebesta, a financial planner in Scottsdale, Ariz.

That being said, if you’re a sole proprietor with modest income, you may find a SEP IRA is limiting in terms of its allowable contributions. In the short term, you can separately fund a Roth or traditional IRA for an additional $6,000 a year if you’re under the age of 50 or $7,000 if you’re 50 years of age or older in 2019 (or $5,500 and $6,500, respectively, in 2018). If you have grander savings aspirations, a solo 401(k) may be a better solution for you.

You can open a solo 401(k) only if you’re a sole proprietor or if your only employee is your spouse. It’s also worth noting that you can take out a loan from some solo 401(k)s, which isn’t possible with SEP IRAs.

If you have employees, a SEP allows you to make contributions for your workers without the hassle of administering a 401(k) plan. But you must contribute the same percentage amount for your employees as you do for yourself. If you wish for employees to make their own contributions or would prefer to contribute a different amount toward your own retirement than toward your employees’ accounts, consider researching a savings incentive match plan for employees (SIMPLE) IRA or traditional 401(k) plan.

Bottom line

It’s important to keep in mind that whatever account you open, it isn’t a life sentence and can be changed later. “I’ve had clients who started out doing a traditional IRA,” said Marguerita Cheng, a financial planner in Potomac, Md. “Their business grew, and they did a SEP IRA, and then their business really grew, and they did a solo 401(k). Their needs changed as their business grew.”

If you’re just starting out, a SEP IRA can be an easy way to sock money away for retirement while also providing a tax break. It’s also a nice benefit to your employees. “It provides a lot of flexibility,” said Cheng.

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Investing

Bitcoin Taxes: How to Play by the IRS’ Rules

Editorial Note: The editorial content on this page is not provided or commissioned by any financial institution. Any opinions, analyses, reviews or recommendations expressed in this article are those of the author’s alone, and may not have been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

Cryptocurrencies captivate and confuse investing enthusiasts and financial pros alike. Are they a smart investment option that will eventually show major gains or a popped bubble? Could they ever be part of a traditional investment portfolio or will they always be an outlier? And how will the Internal Revenue Service (IRS) and other financial regulatory agencies handle any monetary gains coming from Bitcoin, Litecoin, Ethereum, or other cryptocurrencies?

Are there taxes on Bitcoin or other cryptocurrencies?

In a word: Yes. Bitcoin taxes exist. But unlike some sections of the tax code, which can number in the hundreds of pages, the regulations surrounding cryptocurrency and bitcoin taxes are brief — for now. In 2014, the IRS released a notice regarding taxation when it comes to Bitcoin and other cryptocurrencies. This notice is only seven pages long, but broadly states that virtual currency is property, should be treated as such, and, depending on the transaction, may be liable to taxes based on its value on the day of receipt.

The lack of more substantial guidelines have frustrated lawmakers — the House of Representatives issued an open letter to the IRS in September 2018 asking for more clarity in the taxation of virtual currencies, and the Information Reporting Advisory Committee (IRPAC) recommended the IRS provide additional guidance regarding cryptocurrency taxation. For now, both the 2014 notice and previous tax rules applying to short- and long-term capital gains guide the taxation treatment of virtual currency.

If you purchased Bitcoin or another form of cryptocurrency and have it in a virtual wallet as the value rides the market, it is treated similarly to other types of investment vehicles for tax purposes. In short, you don’t need to pay taxes on the crypto itself. That’s because, even though “currency” is in the name, the IRS classifies cryptocurrency as property, which means that it’s treated similarly to a house, stocks or bonds. What this means: If you aren’t withdrawing, selling, or trading any funds, then there is no need to declare your cryptocurrency as part of your tax return.

However, you will need to report gains — or losses — to the IRS through a Schedule D (1040) form, if you have either:

  • “Mined” Bitcoin
  • Used it to buy goods
  • Received Bitcoin as payment
  • Traded or sold cryptocurrencies

Also, if you regularly use Bitcoin instead of cash or credit to purchase items online, it’s important to remember that once Bitcoin is converted to an asset — either cash or goods — the transaction becomes taxable.

Unlike sales of stocks or bonds, where you’re likely to receive a 1099 from your bank or brokerage, it’s up to you to report gains or losses to the IRS yourself. As per the IRS, any gains or losses with cryptocurrency are based on the value of the cryptocurrency at the time that it was bought, sold, or received as payment. Cryptocurrency values constantly fluctuate, so it’s a good idea to get in the habit of tracking values.

If you’re primarily buying or selling cryptocurrencies, you’ll likely be able to download transaction data from your wallet provider, but will need to look up the relative cost of the cryptocurrency bought, sold, or used on the day of the transaction. For example, if you paid for a product from an online vendor with Bitcoin, it’s up to you to assess how much the Bitcoin was worth at the time of sale. That purchase is considered a “taxable event” making your Bitcoin subject to taxes.

Websites like Cointracking.info and Bitcoin.tax are a few of the available online resources that can help you determine tax liabilities.

How much is Bitcoin taxed?

How cryptocurrencies are taxed depends on the length of time you’ve held the cryptocurrency. If you’ve owned the cryptocurrency for less than a year, it’s taxed as a short-term capital gain — the same as your ordinary income tax rate. If the cryptocurrency is held for longer than a year, then any gains will be taxed like long-term capital gains.

For 2018, ordinary income tax rates range from 10% to 37%, depending on your income. For most taxpayers, long-term capital gains are taxed at zero, 15%, and 20% depending on your tax rate. According to the IRS, this means if your ordinary income tax rate is below 15%, you may pay zero on long-term gains. Even if you are in a high tax bracket, you’re going to be paying far less on your long-term capital gains than you are for ordinary taxes, which means that it may be a smart idea to hold onto your cryptocurrency for as long as possible.

Again, bitcoin taxes are dependent on cryptocurrency converting into what the IRS views as a taxable event. In a nutshell, a taxable event is either converting the crypto to cash or using the crypto in a cash-like way.

For example, let’s say a neighbor offers to unload their old car to you for one bitcoin. In the eyes of the IRS, this would be similar to you converting the cryptocurrency to cash (even though no cash changed hands) and it’s up to you to pay taxes on the difference between what you paid for the crypto and what it was worth on the day the sale of the car is final.

Let’s say that you purchased Bitcoin in June 2013, when one bitcoin was valued at about $100. Your neighbor offers to trade her car for one Bitcoin in December 2018, when Bitcoin is valued at $4,000. Because you’ve owned the Bitcoin for over a year, this transaction is seen as a long-term capital gain and taxed at your capital gains rate, which is lower than your income tax rate.

And if you did end up recently losing money in the Bitcoin bubble, it could be possible to use your cryptocurrency transactions as a way to write off the loss on your taxes.

For example, let’s say you purchased one Bitcoin in December 2017, when one Bitcoin cost nearly $18,000. In December 2018, your neighbor offers to sell you her car for one Bitcoin — the day that the currency’s value was at nearly $4,000. Since you lost money in this transaction, you can report a short-term capital loss. But this strategy may have limitations: Even though your Bitcoin lost $14,000 in value from the day you bought the cryptocurrency to the day you transferred it to your neighbor, you’re limited in the loss you can report. The IRS caps short-term capital losses at $3,000 per year on personal tax returns, so you might have to carry that loss forward for years.

However, if you regularly use Bitcoin, it’s also important to be aware that the IRS views any gains from crypto transactions as subject to the net investment income tax if your combined investments (from rental properties, dividends, or other capital gains) is above a certain threshold ($125,000 for single filers in 2018).

If you “mine” for bitcoin, it’s also important to note that the IRS views this activity as employment, with the profits taxable as self-employment income. If your state has income tax, any losses or gains will also be subject to state tax as well.

How to stay out of trouble with the IRS

As cryptocurrency becomes more and more mainstream — and tracking tools become more adept at flagging crypto buys, sells, and trades — bitcoin gains will likely become more heavily scrutinized by the IRS. Along with the rise of cryptocurrency has come the rise of financial pros who have mastered the ins and outs of crypto and bitcoin taxes, as well as how to handle various crypto movements in the market, like “airdrops,” where new forms of cryptocurrencies are given to current investors.

The more you consider how you use crypto, the more questions you may have about how your crypto will be taxed. For example, can you donate crypto to charity? Right now, the answer is yes, with crypto being considered property — similar to gifting stock or real estate — in the eyes of the IRS. If you are planning to donate crypto to charity, it may make sense to donate the cryptocurrency directly to the charity (instead of converting the crypto to cash and donating the equivalent amount) so the charity can receive the full cash value of your crypto gift.

While you can write off the value of your crypto gift on your taxes, you will still be responsible for any capital gains taxes on the money you gave. But if you give the crypto directly to a 501(c)(3) charity while still in crypto form, the 501(c)(3) charity will be exempt from capital gains taxes when the crypto is converted to cash, maximizing the effectiveness of your gift.

Finally, if you’re donating over $500 in cryptocurrency value to a charity, it’s important to make sure to document your donation as though you were documenting any other gift of property. The IRS requires any non-cash gift to be documented with Form 8283, which also applies to crypto.

It’s important to recognize that crypto tax events are subject to worldwide income tax for US residents and citizens regardless of where the crypto originated or where in the world you purchased goods using crypto. And if you’re buying or trading cryptocurrency on a foreign exchange and own over $10,000 in assets, it may be worth speaking with a financial professional who specializes in cryptocurrency. You may need to file a Report of Foreign Bank and Financial Accounts (FBAR) form with the IRS.

As with any tax-related question or concern, more information is better than less information. Consulting with a tax professional, tax lawyer, or financial planner who has experience in cryptocurrency is usually a much better idea in the long run than hoping that you can figure out the right tax move on your own. Just because crypto is a new form of property doesn’t mean that new rules apply to tax evasion. Failure to pay taxes on crypto gains are subject to tax evasion penalties, including potential criminal charges of tax evasion or filing a false tax return, according to a statement from the IRS.

Bottom Line

Even if you’re not actively using crypto to sell, trade, or buy, it makes sense to become familiar with the tax rules surrounding bitcoin now — and realize things are likely to become more codified in the future. Even if you don’t currently own crypto, knowing the way crypto is viewed and how cryptocurrency can evolve from a short- to long-term gain depending on the length its held can help you consider how you might use crypto in the future — or encourage you to hang on to whatever is in your wallet now.

Understanding how the fluctuation of bitcoin prices can work in your favor — and how taxes could potentially affect any purchase or financial move made with crypto — can also help you see the full financial picture. Taking the time to report any crypto transactions now means you won’t need to refile taxes later, saving time and giving you a clear conscience, too.

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Investing

529 Plan Rules: Contributing and Withdrawing Money

Editorial Note: The editorial content on this page is not provided or commissioned by any financial institution. Any opinions, analyses, reviews or recommendations expressed in this article are those of the author’s alone, and may not have been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

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A 529 plan is a tax-advantaged saving plan that helps make saving for education easier by allowing invested funds to grow tax-free and be withdrawn tax-free for qualifying educational expenses.

Also called “qualified tuition plans,” 529 plans are sponsored by individual states or state agencies as well as by educational institutions.

It’s important to research your options carefully to find out what tax breaks are available where you live, as different states and schools have different 529 plan rules. There are different kinds of 529 plans as well, so you’ll need to decide which is right for your family. This guide can help.

What is a 529 plan?

Two types of 529 plans exist that provide tax breaks on federal and state taxes:

  • Prepaid tuition plans: These plans involve purchasing credits at colleges or universities at the current price for someone who will attend school in the future. Most plans are sponsored by state governments and allow tuition and mandatory fees to be prepaid at public and in-state institutions. Students must attend a participating school to get the full value of prepaid credits.
  • Education savings plans: These plans involve putting money into an investment account and using the money to buy assets such as exchange-traded funds or mutual funds. Money can be withdrawn to pay for tuition, room and board, and mandatory fees at any university or college.

Education plans provide more flexibility, but account holders must choose what to invest in, and the investments could lose money. Target-date funds that automatically invest in an appropriate mix of investments simplify the process of selecting investments, but there’s still no guarantee investments will perform well.

Of course, there’s also a risk with prepaid tuition plans unless they’re guaranteed by the state. Some states guarantee the funds, but if your state doesn’t, you could lose some of your investment if the plan sponsor runs into financial problems.

What are the 529 plan rules?

One big benefit of 529 plans is the fact that almost anyone can open one, including parents, grandparents, relatives, friends, and even some corporations. Students can open 529 plans to save for their own college expenses if they are 18 or older.

Whoever chooses to open the account should understand the difference between the account owner and the beneficiary. The child who uses the funds to go to school is the beneficiary. The money is used to benefit that child by covering school costs; however, the child doesn’t have ownership or legal control over the money — unless she is over the age of 18 and opens an account for herself, making her both the owner and beneficiary.

Anyone can be the account owner, but it’s usually a parent. Ownership also can be transferred, with the original owner naming a successor owner. This is helpful when grandparents open an account and then name the child’s parent as a successor owner, for example.

Assets in a 529 savings plan owned by a parent or dependent child are considered parental assets on the Free Application for Federal Student Aid (FAFSA), so they are factored into federal financial aid formulas at a rate of no more than 5.64%. This means a 529 plan owned by a parent or dependent child likely will have a minimal impact on financial aid eligibility. On the other hand, student-owned custodial accounts, such as Uniform Gifts to Minors Act and Uniform Transfers to Minors Act accounts, are assessed at a 20% rate.

What can 529 funds be used for?

While 529 account rules vary by plan, funds generally can be used only for qualifying educational expenses.

If the account is a prepaid tuition plan, funds can cover only tuition and mandatory fees, not room and board. Additionally, funds can pay for those costs only at participating colleges and universities, so if a student chooses to attend a different school, the plan pays for less. If the beneficiary of the plan chooses not to go to school, funds can be transferred to a different beneficiary.

If the account is an education savings plan, the money can be used at almost any college or university and can pay for tuition, room and board, and mandatory fees for undergraduate, graduate or professional programs. The money also can be used to pay up to $10,000 annually for each beneficiary for tuition at public, private or religious elementary or secondary schools.

Contribution limits of 529 plans

Unlike many tax-advantaged accounts, there are no annual contribution limits; however, there’s an aggregate limit that varies by state. Typically, you can’t contribute more than the expected costs of higher educational expenses. Rules vary by state, but limits typically range from $235,000 to as much as $520,000.

While there’s no annual contribution limit, taxes can be triggered if a particular contribution is too large since contributions are treated as gifts. In tax year 2019, a person can give a gift valued at up to $15,000 per recipient without owing gift taxes. That means a relative or friend can contribute up to $15,000 into a 529 without triggering taxes. Additionally, gifts above the annual limit can count toward a lifetime exclusion that allows for $11.4 million per person to be transferred without owing taxes.

529 plans also give you the option to contribute a lump sum of up to $75,000 without triggering gift taxes. That’s because the five-year election option allows you to prorate contributions of $15,000 of more over a five year period. When you make a $75,000 lump-sum contribution, it’s treated as if you’d contributed $15,000 annually over five years.

529 withdrawal rules

Money from a 529 must be withdrawn during the year the beneficiary incurs qualified higher education expenses (QHEEs). Any funds withdrawn to pay for QHEEs will be considered qualified distributions and can be withdrawn tax-free.

Penalties and taxes come into play if money is withdrawn to pay for anything other than QHEEs — or if a child hasn’t incurred enough QHEEs in the tax year to account for the withdrawals. You’ll need to be careful not to withdraw funds in December to pay tuition in January if the child didn’t have enough QHEEs in the year the money was taken out.

There’s one exception to this penalty, though: If the beneficiary receives a scholarship, funds can be withdrawn from the 529 account to offset the scholarship value, and only ordinary income tax will need to be paid.

If you claim the American opportunity tax credit …

Anti-coordination rules also require that you reduce the amount of QHEEs in a year if you claim the American opportunity tax credit or lifetime learning credit. For example, if a child incurred $5,000 in educational expenses but you claimed a $2,500 American opportunity tax credit, you’d have only $1,000 in qualified educational expenses because $4,000 of the money spent on tuition was necessary to justify claiming the tax credit. If you don’t comply with this rule, you’ll owe ordinary income taxes on any money withdrawn — but not the 10% penalty for other nonqualified withdrawals.

If you take out too much money …

If you withdraw too much, you can roll the money into a different 529 plan to avoid penalties. However, you must act within 60 days of the withdrawal, and must not have rolled over money from the same beneficiary’s 529 in the past year. If a period of more than 60 days has passed and you’re still within the calendar year, you can prepay expenses to increase your QHEEs. If the tax year has ended, however, you won’t be able to roll the funds over and then will be required to pay the penalty.

Bottom line

State and federal tax breaks are available for 529 plans, but 529 plan rules vary by state. While these rules are complicated, it’s important to understand them so you can reap all the benefits of investing in a 529 and make saving for college a little easier.

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Investing

What Is a Smart Beta Strategy?

Editorial Note: The editorial content on this page is not provided or commissioned by any financial institution. Any opinions, analyses, reviews or recommendations expressed in this article are those of the author’s alone, and may not have been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

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Smart beta is a fancy term for an investment strategy that seeks to outperform a traditional stock index by reweighting the stocks in that index. It’s a popular strategy, and index managers have created many smart beta indexes that try to earn higher returns with lower risk. It’s like a hybrid approach — using elements from both passively and actively managed styles.

How smart beta works

Smart beta has become a popular investing strategy, having amassed more than $1 trillion in assets by the end of 2017, doubling total assets in just three years. Such strong growth is due to the funds’ promise of higher risk-adjusted returns than conventional index funds offer.

Conventional indexes such as the S&P 500 are weighted by a company’s size. The bigger the firm, the higher its weight in the index. If you buy and hold a fund based on this index, you’ll get the S&P 500’s yearly return over time (an average of 10% to 11% historically, which isn’t bad).

But smart beta indexes seek to do even better. They try to outperform an index such as the S&P 500 while buying the same stocks, only in different proportions. These new indexes select and weight stocks based on criteria that index managers think will lead to a stock’s rise, making them “smart” funds. Beta is a measure of a stock’s volatility, so these indexes seek stocks that deliver the most “bang” for the beta — in other words, high returns with low risk.

These indexes are mimicked by smart beta funds and are reweighted whenever the index changes. Both exchange-traded funds and mutual funds offer smart beta, and there are many different kinds of smart beta strategies, depending on the characteristics an investor wants.

Types of smart beta funds

Each manager has their own way of dicing the conventional index to find outperformance. Managers will analyze and sift the data for what actually drives a stock’s returns, not only at the business but also relative to the economy’s position in the business cycle. How a manager picks these stocks for the index has a key impact on an investor’s overall returns, and one manager’s approach and stock weightings can differ from another’s, even if they share the same style.

Here are some of the most popular smart beta styles:

  • Value: an approach that emphasizes stocks that are cheaper relative to earnings or cash flow
  • Dividends: a style that favors dividend-paying companies or those showing dividend growth
  • Momentum: an approach that includes stocks that have been trending higher
  • Low volatility: a weighting that emphasizes stocks that move around less
  • Business quality: a style that factors in more company-based metrics, including return on equity, low debt and consistently growing earnings
  • Equal weighted: an approach that balances every stock in the index equally

Unlike standardized funds that are based on the S&P 500 or the Nasdaq composite, funds with the same style offer no guarantee that they’ll be the same on the inside. And a fund itself will shift as managers alter the index in response to new analysis or changing market conditions.

In fact, you should expect each fund to be created differently. After all, you’re paying the manager extra for this expertise — to try to find that increased return without the extra risk.

The advantages of smart beta investing

Smart beta funds promise investors higher risk-adjusted returns than conventional index funds or strategies. That means investors could earn the same return with lower risk or perhaps a higher return with the same risk as a conventional fund. So investors get a “free lunch” without having to compromise. If the manager can achieve that goal, it’s a win for investors.

And there’s some evidence that at least some managers can do this. In a 2018 analysis, investment manager Invesco examined smart beta strategies from 1991 to 2017 across five market cycles. Researchers discovered that all smart beta strategies produced the same or better total returns than the S&P 500, while the majority produced better risk-adjusted returns.

If smart beta works as promised, investors get higher risk-adjusted returns (at least most of the time) while enjoying the benefits of a diversified stock portfolio.

The risks of smart beta investing

Remember what they say about free lunches? There’s maybe no such thing in the case of smart beta investing, at least in aggregate. Smart beta may excel for a time, but as an approach becomes more popular, it loses its ability to outperform. To say this another way, in the game of stock trading, one person’s win is always another’s loss. Outperformance for one smart beta fund means underperformance for another smart beta fund.

It may still be possible to find a smart beta fund that can outperform the market, but in aggregate, smart beta won’t do better than a passive approach. In fact, because of higher fees paid to active managers, it will cost more, dragging the average investor’s overall returns lower. So if you’re looking for a smart beta fund, choose one with a track record of outperformance.

On the subject of fees, some analysts estimate the average smart beta fund costs about 0.35% to 0.39%, or $35 to $39 for every $10,000 invested, though fees have been falling. That’s not especially high, but it’s still well above some of the lowest-cost S&P index funds, such as the Schwab S&P 500 (SWPPX) at 0.03%, or $3 for each $10,000. So any smart beta fund you choose must outperform by that extra cost just to break even over the cheaper fund. While it may seem small, that little difference adds up over a lifetime of saving and investing.

One other concern may be harder to detect for investors, and it revolves around the question of risk. Index managers are creating indexes that purport to lower risk while still achieving returns. However, it’s possible that a manager is taking on too much risk to achieve that return. So returns can look good during a bull market, but they can turn much worse during a bear market. Worse, it’s hard for an investor to make a call on whether a fund is taking on too much risk.

Bottom line

Smart beta has become popular because of its promise to provide investors with better risk-adjusted returns. While there’s some evidence of that, not all strategies can always be winners. It’s just not the way the world of investing works.

But it may be possible to find a manager who is able to consistently outperform with smart beta, and if so, it’s important to stick to the same buy-and-hold mentality that drives the returns of many great investors.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

James F. Royal, Ph.D.
James F. Royal, Ph.D. |

James F. Royal, Ph.D. is a writer at MagnifyMoney. You can email James here

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Investing

Choosing Mutual Funds: 7 Things You Need to Know

Editorial Note: The editorial content on this page is not provided or commissioned by any financial institution. Any opinions, analyses, reviews or recommendations expressed in this article are those of the author’s alone, and may not have been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

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When it comes to investing, mutual funds are a basic building block. About 44% of U.S. households and 94 million individual investors own mutual funds, according to a 2017 study from the Investment Company Institute (ICI). And they like them — more than 8 in 10 mutual fund-owning households believe mutual funds can help them reach their financial goals.

That said, knowing how to choose mutual funds isn’t always a slam dunk. There are some things you should understand before diving in.

How mutual funds work

A mutual fund is essentially a group of investments that have been put together to achieve a desired kind of return. When you buy a share of a mutual fund, you are buying a small piece of all the investments, so mutual funds are a useful way to diversify without needing to choose (and buy) individual stocks, bonds or other types of securities.

Mutual funds come in a variety of flavors, from those that track an industry, such as health care or energy, to those that track an index, such as the S&P 500 or the Dow Jones Industrial Average. Some are designed with your target retirement date in mind — getting more conservative as you get closer to quitting work. Others invest entirely in large or small companies, fixed-income and even international stocks. As of 2017, there were 9,356 mutual funds in the United States, according to the ICI — so it’s a wide field.

How to choose mutual funds

There are many strategies you can use to select mutual funds for your own portfolio. Knowing these seven key considerations will help you determine the right types of funds to meet your investing goals.

1. Define your purpose

First and foremost, what do you plan to do with the money you’re investing? Is it for retirement? College? A down payment on a house?
Answering this question will help inform the types of mutual funds you would consider. For instance, if you’re saving money for a down payment for a home, you probably wouldn’t invest it in a target-date retirement fund.

2. Assess your risk tolerance

How do you feel about losing money? How do you feel about losing a lot of money? “Everybody likes to make money, but what happens if, out of nowhere, it just gets ugly?” asked Peter Creedon, a financial planner with Crystal Brook Advisors in Mount Sinai, N.Y.

Whether you’re a younger investor with a lot of time to be aggressive or an investor nearing retirement who needs to be more conservative, there are mutual funds to match both approaches — and plenty in the middle. Try this risk tolerance assessment from the University of Missouri to get a better read on where you stand.

3. Examine the costs involved

Some mutual funds carry a sales load, meaning you must pay a fee to purchase or redeem them. Experts recommend steering toward no-load funds, which are mutual funds without those types of fees, instead. The less you pay on the front end, the more you’ll have available to invest overall. “No-load funds are plentiful, and there are many high-quality options,” said Kristi Sullivan, a financial planner at Sullivan Financial Planning in Denver, Colo.

You also should take note of the expense ratio on a fund, which represents the annual operating costs of running the fund. The lower the expense ratio, the more you’ll take away in earnings.

“If you own a fund where the gross return was 10% during the year and the expense ratio was 2%, then you are only netting 8%,” said Ted Toal, a financial planner with RCS Financial Planning in Annapolis, Md. “And studies have shown that funds with lower expense ratios tend to have better performance over time than funds with higher expenses.”

4. Look at the turnover ratio

Turnover ratio is a measure of how frequently the investments within a mutual fund are bought and sold each year. The higher the ratio, the more often that’s happening. If you’re investing within a tax-deferred account — such as a 401(k) or IRA — this measure doesn’t matter, but if you’re investing within a brokerage account, funds with high turnover can bump up your tax bill.

In either case, high turnover can boost transaction costs. “Anytime a fund makes a trade, they have to pay commissions on that trade,” Toal said. “The more they trade, the higher the trading costs for the fund, and that subtracts from the return of the investor.”

5. Weigh active vs. passive management

An actively managed fund means there’s a fund manager who is actively buying and selling securities based on what they think is best and aiming to outperform the market. Passive management, on the other hand, means a fund is automatically pegged to a benchmark or index, such as the S&P 500.

While it might seem like you’d want someone working for the best result, actively managed funds tend to come with higher fees, and the majority lag behind the market over time, according to research from S&P Global. Passively managed funds, meanwhile, mirror market returns and generally carry lower expense ratios — a win-win.

6. Don’t put much stock in past performance

Sure, you can look at how a fund has done in the past, but don’t make your decision based solely on track record. “Good past performance could be luck or a skill set that was trending at the right time at the right place,” said Mitchell Kraus, a financial planner at Capital Intelligence Associates in Santa Monica, Calif. “It’s very easy to create a portfolio or find funds that have great past performance. The trick is finding funds that will perform well moving into the future.”

If you’re determined to use track record as a metric, compare a mutual fund’s history to that of its peers. “Too many clients will see a fund that went up and buy into it, and most of that return was based on being in an asset category that had done well,” Kraus said. “There are funds that underperformed the market as a whole but have overperformed their peers in their asset category, and those are the funds that are important to look for moving forward.”

7. Make sure you’re diversified

While it’s acceptable to own funds with a very specific focus — technology stocks, for instance, or high-yield bonds — it’s not wise to put all your money into a single area of the market.

“You can make as many guesses as you want, but we simply don’t know what is going to perform well in any upcoming year and what’s going to perform poorly,” Toal said. “It’s best to generally own everything so you don’t have to guess. In the long run, you should come out with the average return of the market.”

Bottom line

Mutual fund investing can be a little overwhelming. There are thousands of funds available, you’ve got limited time to research them, and everyone has an opinion about where you should put your money. But if you have done your due diligence, are investing regularly and are diversified, you probably will be in good shape. Just stick with your plan.

“With all the information available today, it’s easy to get distracted and think there’s something better out there,” Toal said. “What most people will find is by constantly moving your money, usually you’re going to earn much less over time than if you just pick a good fund, stick with it and keep putting money into it.”

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Kate Ashford |

Kate Ashford is a writer at MagnifyMoney. You can email Kate here

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