A new year—and a chance to start out fresh—but only if you seize the day and take advantage of the retirement opportunities that are available to you now. What steps can you begin taking now that will supercharge your retirement investing?
Maximize your retirement contributions
When I say maximize your retirement contribution, I’m not referring to the maximum contribution you’re allowed under either IRS regulations or your employer’s 401K or 403B plan, but the most you can afford to fund. If you already contribute the maximum, there’s no decision to be made, but if you’re contributing less, January is the perfect time to increase it.
Here’s another reason for increasing your contributions early in the year…the earlier in the new year you increase you’re contributions, the less you’ll have to make on a per contribution basis. For example, let’s say you decide you want to increase your contributions by $2,000 for 2012; if you begin in January you’ll only need to increase your contributions (on a monthly basis) by $167. If you delay the change until July, you’ll need to increase your contributions to about $334 in order to reach your goal.
Moral of the story: earlier is easier.
Check your portfolio allocations and rebalance if necessary
If you’ve set portfolio allocations to maintain adequate diversification with your retirement investments, January is the perfect time to rebalance them to make sure that you haven’t become overweight in some investment classes, and underweight in others.
Rebalancing should be done at least once a year, and if you do it at the beginning of the new year, you won’t have to worry about it for the rest of the year—unless of course, you like to rebalance more frequently.
Get out of last year’s investments
A lot can change in a single year, especially when it comes to investments. The “investment guard” tends to change frequently, and the beginning of the year is an outstanding time to review investment performance to determine if certain investments have fallen out of favor, and to identify new ones that have greater potential.
Since retirement investing is long-term investing at its finest, there may be a tendency to rely on very long time horizons to make your investment plays work. While that can happen with some investments, most tend to come and go, and last years winners can become this year’s losers before you know it.
Investigate non-tax sheltered retirement investments
This is especially important if you already max-out your retirement contributions. Any investment can be a retirement asset, whether or not they’re tax sheltered. Obviously tax sheltered status is better than non-tax sheltered, but non-sheltered is the next best investment.
In addition, non-sheltered investments can provide a form of tax diversification in combination with your sheltered plans. It would provide you with a source of retirement capital that won’t be subject to taxation or minimum required withdrawals at retirement.
Implement a credible plan to eliminate your debt
Most people don’t think of paying off debt as retirement investing but it really is, albeit from a different direction. Though you’re not pouring money into appreciating or income producing assets, you are “investing” in debt elimination. A paid debt translates into a reduction of future expenses, and that means less investment income is needed to cover that expense.
Building an income producing retirement investment portfolio is the first, best way to prepare for your retirement, but eliminating debt comes in a close second. This is especially true of mortgage debt, because it represents structural debt—the kind that eats up a big chunk of your income and does so for many years.
Invest your income tax refund in an IRA
Tax refunds are like found money, and the best thing to do with them is to invest them where they’ll make a long-term difference. And there’s no better place to do that than in a tax sheltered retirement plan, like a traditional or Roth IRA. If you don’t have an IRA, here’s your chance to make it happen. Invest your refund in one of these, and it will continue to provide you a monetary benefit for the rest of your life.
Though the refund may not come in time to fund an IRA deduction for the most recent tax year, it will give you a benefit for next year. And even if the IRA contribution isn’t tax deductible, you’ll still have converted a one time windfall to a permanent asset!
It’s 2012, and the time to get moving on these is now. If you wait to do them later, they’ll just go on the heap with other new years resolutions that weren’t!
Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry and lives in Atlanta with his wife and two teenage kids.
It’s too late to make a significant impact on your financial situation in 2011. (However, you can still contribute to a Roth IRA for 2011 up until April 15, 2012.) Today is the start of a new year. Will it be the year you change your situation for good? Will you set up automatic payments to a Roth IRA?
Here are some great articles to get started on changing your finances this year:
Our top 3 posts are…
Consumerism Commentary: The 3/50 Project: Help Your Local Economy
The Simple Dollar: How I Switched to Long Term Thinking
CNN Money: Investing in 2012: Resolve to Keep It Simple
These are great, too…
I Will Teach You to Be Rich: The Psychology of Buying High and Selling Low
Five Cent Nickel: Tips for Returning Unwanted Gifts
Couple Money: Our 2012 Financial Goals
Boomer and Echo: Should You Keep Your Company Pension Or Take The Commuted Value?
Free From Broke: Stay on Top of Credit Card Payments – How to Make Sure You Pay Your Credit Card on Time
Personal Dividends: Adjusting Your Investment Portfolio for 2012
Get Rich Slowly: Expectations and Your Money
This article is by our Senior Editor, Kevin Mulligan. He is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. Kevin’s been utilizing a Roth IRA to save for retirement since 2008.
Aren’t you looking for higher returns right now? Who isn’t?
Here are some popular options to earn some sort of return these days:
- ING Direct savings interest rate: 0.85%
- Average brick and mortar savings interest rate: 0.20% or less
- A high yield bond fund: 4%
- A utility company stock with a dividend: 4%
As you can see the options aren’t very attractive. That leads to the want or need of higher returns, and the search is on. We’ll look anywhere to satisfy this need… financial magazines, mainstream blogs, niche paid newsletters, and friend-of-a-friend recommendations.
But be careful! Chasing returns can and will burn you… badly.
Two Reasons Chasing Returns Will Hurt Your Portfolio
There are two main reasons that only focusing on earning the highest returns will, in the long run, do more harm than good.
Higher Return, Higher Risk
Keeping a constant focus on earning the highest return seems like a good idea. We could all use a few extra percentage points this year, right? But chasing the best returns is different from the highest returns.
With high returns comes high risk. A few years ago several real estate investment trusts (REITs) were offering dividend yields in the 10-15% range. Many investors hopped on the eye-popping returns only to lose 100% of their investment when the company went belly up during the housing crisis. The stock market is the culmination of the idea that with higher risk come higher returns. If you chase higher returns by buying individual stocks you could win big, but you could also lose big, too. High returns inevitably come with high risk. The more exotic the investment, the higher the risk, and the more enticing it can be. You might be able to get great returns by dumping money into that new condo building going up — the guy pitching you seems really honest, so why not? — but it might cost you everything you have, too.
Misplaced Focus
Focusing only on the highest returns possible is a misplaced focus. These are three areas that make sense for most investors to focus on:
- Accept Average: With investing, being average is great. That means using index mutual funds so that you earn whatever the index earns. You avoid the ups and downs of actively managed funds.
- Lower Expenses: With index funds comes lower mutual fund expenses. Even if you aren’t using solely index mutual funds (maybe ETFs come into the mix for you), a focus on lowering your expenses is one of the only ways to truly save money when investing.
- Consistent Investment: Being consistent in your investments is much more important than squeezing the highest returns from fewer investments. You can’t squeeze blood from a rock, and you can’t squeeze $1,000,000 in returns from a $5,000 Roth IRA investment. You’d be much better off setting up a system to consistently invest $5,000 every year so that, over time, you get to that $1,000,000 mark.
I mentioned earlier that chasing the best returns is different from chasing the highest returns. The best returns are those above: an average return with minimal expenses. That strategy mixed with consistent investment is the best return you could ask for.
This article is by our Senior Editor, Kevin Mulligan. He is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. Kevin’s been utilizing a Roth IRA to save for retirement since 2008.
For many investors, a Roth IRA is a better investment than contributing to your employer’s 401k retirement plan. A Roth IRA is cut from much of the same cloth as a 401k retirement plan, but there are several characteristics that make a Roth IRA a better investment option for many Americans. While this is obviously not true in all circumstances, the tax advantages of a Roth IRA often make it an incredible investment vehicle for to help you accomplish your financial goals for retirement.
Photo by Kevin MulliganA Roth IRA Is More Tax Efficient Than A 401k
The largest benefit of a Roth IRA is its tax-free withdrawals of earnings in retirement. Investors use after-tax dollars from their paycheck that has already been taxed to invest in their Roth IRA accounts. If you withdrawal the account’s earnings after reaching 59 ½ years-old, the earnings are then tax free. This tax-free status is one of the biggest reasons that set a Roth IRA apart from a 401k retirement plan. Many investors are in a lower tax bracket while they are starting their career, and ultimately they should be in a much higher income tax bracket later in their lives when they are ready to retire. This is a great benefit to Roth IRA investors who pay their taxes early in the investing process. Conversely a 401k retirement plan investor reduces his or her taxable income when he makes an initial investment but pays taxes when funds are withdrawn later in his or her career.
A Roth IRA Is More Flexible Than A 401k
A Roth IRA allows investors more flexibility than a 401k retirement plan. Investors can designate mutual funds as a Roth IRA if they meet the income limits and qualify to invest in a Roth IRA. Investors also have the ability to designate their investment as a self-directed Roth IRA and can decide which investments to exactly include in their Roth IRA. A 401k retirement plan with your employer often limits an employee’s investment choices to a select few mutual funds and investment options. For example, the federal Thrift Savings Plan which is the government’s equivalent to a 401k retirement plan only offers five different index fund options for investors to choose from. Also while you can take a loan out against most 401k retirement plan, you are severely penalized if you withdrawal your investment from a 401k before you reach 59 ½ years-old. A Roth IRA on the other hand provides you with several opportunities to take an early withdrawal without penalties to pay for qualified exceptions such as a home purchase, educational expenses, if you become severely disabled, or other specific instances.
Additional Investment Characteristics To Consider
Of course there may be times when you need to invest in a 401k retirement plan in conjunction with your Roth IRA. You should consider investing in a 401k plan if your employer offers a matching contribution. Many employers match up to 5% of an employee’s investment contribution which is essentially a 100% rate of return. There is also an income limit that sets a cap to who can invest in a Roth IRA. If you are married filing joint tax returns and earn more than $183,000 per year, you do not qualify to invest in a Roth IRA.
In many cases, a Roth IRA is often a superior investment over a 401k retirement plan. A Roth IRA offers investors a flexible investment vehicle to save for retirement while also minimizing the amount of taxes that will ultimately have to be paid. While a Roth IRA is not available to all investors and exceptions can apply, a Roth IRA is often a better investment than a 401k retirement plan.
Hank Coleman is a freelance writer who specializes in personal finance, investing, and retirement topics. He is the founder of several personal finance sites including Money Q&A. Hank has written for many sites such as Fool.com, Five Cent Nickel, Discover Bank, and many others. Follow him on Twitter at @HankColeman.
If you have a traditional pension plan at work, you have nothing to worry about—you’re retirement is covered, right? Maybe not. The world is changing and like a lot of other things, they’re just not making pensions the way they used to. And even if you do have a pension plan…well, again, the world is changing.
Moral of the story: don’t take anything for granted, least of which a pension.
The long and short of traditional pension plans
One of the principal problems with employer pensions is that relatively few people have them anymore. Up until the 1970s most workers were part of traditional plans, also known as “defined benefit pensions”, so named because benefits are based on metrics such as income level and years of service, and are completely funded by the employer.
During the 1970s the government created several “defined contribution plans”, such as 401Ks and IRAs, that are fully funded by the employee and depend largely on the size of the contributions and investment return. While these were welcome creations for the self-employed, few realized at the time that they would eventually replace the cherished traditional pensions that workers had grown accustomed to. Defined contribution plans cost employers less to maintain and fund, and put the burden of retirement planning on the employee.
Simply put, traditional pensions are not part of the typical retirement planning profile.
Government employees: the exception – for now
There is one class of employees who are an exception to the pension rule, and that’s government employees. Traditional defined benefit plans are still the order of the day for most employees of government, whether they work at the federal, state or municipal level.
While it may be comforting to assume that your retirement needs will be fully met by a government pension, recent events are calling even these into question. Many state and municipal employee pension plans are facing substantial shortfalls to cover future obligations, providing more than a hint that such pension plans will be less generous as we move forward.
It’s probably not yet time to panic, but it’s an excellent time to start making some other plans.
Get the full scoop on your employer’s retirement plan
If you do have a traditional pension plan through your employer, the first order of business is to contact your human resources department to determine what kind of income level you can expect at retirement. This is usually based on a percentage of your income, and that percentage increases with the number of years you work for your employer.
Once you have that projected monthly income number, you can add it to your expected monthly Social Security benefit to determine if the combination of the two will be sufficient to provide the income level you’ll need to afford the type of retirement you’re expecting. If not, you’ll have to look at defined contribution alternatives, such as traditional and Roth IRAs, to make up the difference.
You don’t control your employer’s pension plan
As great as having a traditional pension plan is, you have to consider that you don’t have any control over it. Your employer has absolute control over a defined benefit plan (subject of course to federal law), and that means that they can change benefit calculations, reduce benefits or even terminate the plan.
That last point is critical. Since the 1970s thousands of employers have terminated their traditional pension plans in favor of defined contribution plans. Sometimes they’ll arrange a payout to employees for their portions of the plan to date, but in other cases they can leave the funds in a poorly managed account that will pay meager benefits until the last pensioned employee dies. Either way, you won’t get the expected monthly benefit if this happens.
Still another issue here is that of tenure. Truth is, most employees today don’t (or can’t) stay with their employers for the 20, 30 or 40 years it takes to earn a generous monthly pension benefit.
Watch out for inflation
Inflation is the “X Factor” in retirement planning. No one knows what price levels will be decades from now, but the problem is magnified with traditional pensions. Most private employer pension plans establish a fixed monthly benefit at the beginning of retirement that they’ll pay out for the rest of your life. While that might be very generous in the early years of retirement, you’ll begin to feel the pinch in ten years or so when your monthly benefit just doesn’t buy as much as it did.
Government pensions typically have some type of cost of living adjustment (COLA), which at least partially addresses this concern. But again budget problems are becoming a factor, and an even bigger concern is the definition of inflation itself. COLAs are generally based on the Consumer Price Index (CPI), which is a general purpose index that doesn’t address specific prices. For retirees, for example, healthcare is a major component of a household budget and price levels in that sector are rising much faster than in the general economy. If the CPI is 2%, but your personal rate of inflation is 5%, you’ll fall behind even if you have a COLA provision.
Again, some type of supplemental provision needs to be made even if you’re expecting a government sponsored, COLA-adjusted pension plan.
Fund your retirement, and think of a pension as a bonus
Perhaps the best course of action in regard to pension plans is to consider them to be a bonus. Establish and fund self-directed retirement plans, such as 401Ks and 403Bs if your employer offers them, or traditional or Roth IRAs if they don’t.
Still another way to prepare for retirement is to build up non-retirement investments (stocks, mutual funds, investment real estate), work to get out of debt and even investigate the possibility of post-retirement career opportunities.
A traditional pension is great if you have one, but never assume that your employer has your retirement fully covered. Ultimately, the quality of your retirement is your responsibility first and foremost.
Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry and lives in Atlanta with his wife and two teenage kids.
By my calculations you have less than 24 hours to run out to the mall or your favorite discount retailer to grab that gift, wrap it up quickly, and get it under the tree. Don’t worry, you aren’t alone; there will be many other people out doing the same thing as you. Hopefully you’ve been smart and got all your shopping done long ago.
Can how you handle the Christmas season be an indicator of how well you handle your finances? Did you plan everything out, knew where you were shopping and how much you were spending, and finished early? Or are you still scrambling and reacting to the latest gift “emergency”?
If you already wrapped up your holiday shopping, here’s some articles to read while you sit by the fire. (For those of you left shopping until the last minute, catch up on these sometime next week!):
Here are our top three posts of the week…
CNN Money: Gold coints, diamonds land in Salvation Army kettles – Apparently they didn’t want the tax deduction?
I Will Teach You To Be Rich: Fortune’s 6 Page Profile on Me – Get a peek into the world of PF guru Ramit Sethi (make sure you read the Fortune article he links to as well)
Planting Money Seeds: Value vs. Cheap: What is True Frugality? – There is a significant difference. Do you know it?
And these are great reads as well…
Free From Broke: What Are the Best Ways to Invest in Mutual Funds?
Consumerism Commentary: Paying Off Layaways at K-Mart
Passive Income Now: What’s The Point of a Landlord Credit Check?
Five Cent Nickel: How to Give Your Budget a Tune-Up
Boomer and Echo: An Investment Book On How To Reduce Mutual Fund Fees And Expenses
Get Rich Slowly: Learn More About Money From an Investment Group
Couple Money: Time to Look at Home Insurance Quotes
NPR’s Planet Money: The Year in 4 Charts
Bible Money Matters: Free, Cheap And Affordable Ways To Backup Your Digital Data
The Simple Dollar: How to Find Good Stuff at Goodwill and Other Secondhand Stores
This article is by our Senior Editor, Kevin Mulligan. He is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. Kevin’s been utilizing a Roth IRA to save for retirement since 2008.
As you are wrapping up your financial year, you want to make sure to maximize any tax savings you can. That means harvesting your tax losses in your portfolio, paying your mortgage for January of next year in December to get the interest deduction, and donating to charity. You normally have until December 31st to donate to your favorite charities and non-profits for a tax deduction, but be sure to check with your specific charities first.
A Last Minute Donation Checklist
Here’s a checklist to help you get through the hectic end of the year while still grabbing those tax deductions.
Documentation
The IRS watches your tax deductions and charity donations as part of the audit flagging process on your tax return. You want to make sure you aren’t claiming an abnormal amount of tax deductions. If you do have a lot of deductions due to a lot of charity work in the year — and really, even if you donate just a normal amount — having solid documentation around your charity deductions is key.
The documentation needed depends on what you are donating to the charity or non-profit organization.
If you’re donating…
- money: Whether you’re giving cash, a check, or donating via credit card like some charities allow, you need to get a written or printed receipt of your donation. If you give regularly throughout the year many organizations will set up a profile for you in their accounting system and provide you a year end statement of giving. Be sure to check it against your records so that all of your donations count as deductions.
- items: Claiming a proper deduction amount for the items you donate is key to not getting in trouble with the IRS. Just because an item is priceless to you doesn’t mean your Mom’s coffee cup is worth $20. The government puts out a list of donated item values every year as tax season begins. Use it as a guide. Also, make sure you not only get a receipt, but take photos of the items you donate just in case you do get audited and need proof an item was an excellent condition.
- securities: You can donate securities to charities, but there is proper paperwork that needs to be filled out. You will need this documentation to file your taxes correctly and to get the proper amount of tax deduction.
Other Donation Tips
Looking to cut your taxes even further? USe these tips:
Mileage
You can deduct mileage for any legitimate time spent volunteering for a non-profit. The IRS consistently updates the mileage rates for all types of driving. This year charitable driving can be deducted at 14 cents per mile. It might not be much, but every little amount reducing your taxes helps.
Is the Standard Deduction Better?
As you are doing all of your calculations for your deductions, make sure you won’t benefit from just taking the standard deduction first. It doesn’t do you any good to have $3,000 in donations when you could take the $5,700 standard deduction for singles.
This article is by our Senior Editor, Kevin Mulligan. He is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. Kevin’s been utilizing a Roth IRA to save for retirement since 2008.
While a Roth IRA was designed primarily as a retirement plan for American citizens, the account’s flexibility allows it to be used for other financial goals besides retirement. The United States government has set up Roth IRAs to allow individuals to withdrawal funds from the account early and allow the proceeds to be used to pay for other things besides retirement. Typically investors cannot withdrawal their earnings, interest, and income from a Roth IRA until you reach 59 ½ years-old. (You can always withdraw your contributions penalty and tax free.)
An early withdrawal that does not qualify for an exemption is considered a non-qualified Roth IRA distribution. Early withdrawals not exempt are subject to a 10% penalty and taxation by the Internal Revenue Service (IRS). So, what are a few alternative uses allow for Roth IRAs?
Use A Roth IRA To Buy A House
You may withdrawal funds from your Roth IRA to buy a house before reaching 59 1/2 years-old. Your investment in the Roth IRA must have met the 5 year rule, used directly for purchasing a home as a down payment or closing costs, and you cannot withdrawal more than $10,000 from your Roth IRA for the home purchase. Early withdrawals for a home purchase from a Roth IRA are both penalty and tax-free.
Use A Roth IRA To Fund Education
Another alternative to You can withdrawal money for college from your Roth IRA if you have to. While you can withdrawal your investment to fund college education expenses, there are a few limitations that you must consider beforehand. You can withdrawal your contributions tax-free from a Roth IRA at anytime, but you must pay taxes on your earnings if you withdraw them before you reach 59 1/2 years-old and use the money to fund education expenses. There is no 10% early withdrawal penalty if it is used for qualified education expenses. Qualified education expenses are tuition, fees, books, supplies, equipment, and room and board (in most cases), and you can use the funds for educational expenses for yourself, your spouse, your children or your grandchildren.
Use A Roth IRA To In An Emergency
You should have an emergency fund in place to help you in the event of an emergency. In fact most financial planners recommend that you should have three to six months of living expenses saved in an emergency fund. But, what if you don’t have an emergency fund available? If it is a true emergency, then you can carefully consider withdrawing money from your Roth IRA to help. This should be used as a last resort. There are serious consequences such as a 10% penalty and taxes if you prematurely withdrawal your earnings from a Roth IRA. Consider only withdrawing a portion of the contributions that you invested in your Roth IRA in order to avoid paying penalties and taxes should you need to raid your Roth in an emergency.
One of the best features of a Roth IRA is its flexibility. Senator William Roth and his committee developed the retirement plan to mirror the American Dream. With a Roth IRA’s flexibility, you can withdrawal money in order to fund different financial goals that you may have such as buying a home or sending your children to college.
Hank Coleman is a freelance writer who specializes in personal finance, investing, and retirement topics. He is the founder of several personal finance sites including Money Q&A. Hank has written for many sites such as Fool.com, Five Cent Nickel, Discover Bank, and many others. Follow him on Twitter at @HankColeman.
Can you really save money by investing in exchange traded funds (ETFs) rather than stocks or mutual funds? Yes—at least a little—and that can make a huge difference if you’re investing for the long-term such as you would for retirement accounts.
Though the difference in expenses between ETFs and stocks can be expected to remain for the foreseeable future, the advantage over mutual funds may become less significant as time passes. That is because ETFs and mutual funds are locked in an ongoing competition for the investor’s dollar, and that means the difference in fees will only narrow going forward.
Photo by 401K via FlickrFor now however, there is enough of a cost difference between the two that ETFs are the better choice.
ETFs vs. Stocks
Just for the fact that you’re buying and selling them in large blocks, ETFs will be less expensive to buy and sell than a comparable dollar value of individual stock positions.
Diversification is a major factor with investing, and it’s easy to accomplish with ETFs, especially since they’re generally tied to various indexes that enable you to diversify either within a given market or within a specific industry group. You’d have to buy a lot of individual stocks in order to obtain that level of diversification, and the transaction costs for doing so would be significant.
ETFs offer a real cost advantage over stocks, but do they save money compared to mutual funds and the various costs each involve?
Saving on expense ratios
The largest way that ETFs can save you money over mutual funds is through smaller expense ratios. The difference may seem insignificant on the surface level, but compounded over years and decades of holding an investment and that difference becomes significant. The average mutual fund (both actively managed funds and index funds) has an expense ratio of 1% of assets. That means for every $100 you have in the investment, the company will keep $1. That doesn’t seem like a lot. However, when you compare to exchange traded funds that offer expense ratios as low as 0.07% (that’s 7 cents on every $100 invested) it starts to look significant. That potential 93 cents saved on every $100 invested, every year, can add up to a significant boost to your portfolio. Lower expense ratios is one of the key reasons to convert your mutual funds to ETFs.
Saving on transaction costs
The differences in transaction costs between mutual funds and ETFs tend to even out. This cost isn’t always easy to figure out since the application of transaction fees depends on how and where the positions are bought and sold. Typically, if various mutual funds are held in an account with the fund company, transfers between one fund and another will not incur a transaction fee — as long as the transfer is within the fund family of the host broker (ie, one Fidelity mutual fund to another Fidelity mutual fund within an account held with Fidelity Investments). However, a move between unrelated funds or, typically, any fund transfers held by a brokerage (non-mutual fund) company will generally cause a transaction fee, whether you’re investing in ETFs or mutual funds.
There is a possibility to avoid transaction costs entirely with ETFs but it depends upon how and where the funds are held. Many of the major brokers offer free trades between their own ETFs, but some, such as TD Ameritrade offer free commissions on over 100 ETFs. It will be necessary to check the transaction policies specific to each broker in order to determine if there is an advantage one way or another.
Saving on income taxes
This isn’t a factor if your mutual funds are held in tax-sheltered retirement plans, but they can be substantial for your non-sheltered investments.
Because mutual funds are actively managed by fund managers who are working to achieve the best investment returns possible, they tend to create tax liabilities in the process. Fund managers buy and sell stocks, which is the source of the “capital gains distributions” that show up on the 1099 forms you receive from the fund companies at tax time. You may not have sold any of your mutual funds shares during the year, but any security sales within the fund itself will create a capital gain if the sale resulted in a gain on sale on any individual stock sold.
ETFs are index funds, which means they don’t buy and sell shares to produce gains, but rather to maintain the index correlation within the fund. That means far less trading, and a far lower likelihood that capital gains distributions will be incurred. This lower incidence of capital gains taxes can not only lower the expense of investing through ETFs compared to mutual funds, but it can also have a material effect on investment performance over many years on any investments that don’t have the benefit of tax sheltered status.
Saving on management fees
Since ETFs have passive management, it follows the management fees will also be lower than they will be with more actively managed mutual funds.
Mutual funds also have 12(b)-1 fees (annual marketing or distribution fees normally amounting to .25 to 1.00% of the funds value), which are stealth fees built into the fund and its performance that investors rarely see. They may be only a fraction of one per cent, but they can add up over 20-30 year. Mutual funds sometimes have redemption fees when the fund positions are liquidated, and those fees are more substantial, usually several percentage points of the funds value at liquidation. ETFs have neither.
Does that mean you should invest ONLY in ETFs?
Nope, not even close. The difference in costs between ETFs and mutual funds isn’t enough to render mutual funds useless as an investment choice. You want to reduce any costs associated with investing—retirement investing in particular—but what you’ll save won’t make or break your investment performance. And while ETFs offer a definite cost advantage over individual stocks, having a few individual positions in your portfolio may allow you to take advantage of special situations that funds of any sort can’t provide.
When it comes to retirement investing, it’s far more important to maximize funding levels to your various retirement plans and to make sure they’re both property invested and adequately diversified. All of those efforts will have a far greater impact on your retirement investment results than the fees you’ll save with ETFs.
Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry and lives in Atlanta with his wife and two teenage kids.
Congress has been unable to decide on whether or not to extend the payroll tax cuts that have been in place for quite some time. With the government still trillions of dollars in the red you would think they would let the cuts expire to recoup some of that loss revenue. But allowing previously enacted tax cuts to expire is politically unpopular. Instead of truly addressing the problem Congress decided to kick the can down the road a little bit further. Not too far, just enough to get us into 2012.
Would you let the payroll tax expire? How would you fix the federal budget?
These are our top 3 posts of the week…
Retire Happy: Year End Tax Tips
Free From Broke: Unemployment Extensions In Jeopardy – What Long Term Jobless Should Consider Doing
Five Cent Nickel: The Ethics of Saving Money
But these are great too…
Couple Money: Reviewing Our Family’s 2011 Budget
Bible Money Matters: What Are The Rules For Inheriting A Roth IRA?
Boomer and Echo: MBNA Canada’s Aggressive Marketing Tactics
Studenomics: How Can You Improve Your Credit Score Right Now?
Consumerism Commentary: Year End Reminder: Balance Your Portfolio
Get Rich Slowly: Reader Story: Finding Financial Balance
The Simple Dollar: Savings Account as Investment
This article is by our Senior Editor, Kevin Mulligan. He is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. Kevin’s been utilizing a Roth IRA to save for retirement since 2008.
January 2nd, 2012
