Personal Finance Test 4 Review

Instances where you may be able to take money out early from a retirement account without a penalty

(1) expenses for medical, college, and home buying (IRA account not employer sponsored) (2) account loans (3) hardship withdrawal: xamples are unreimbursed medical expenses, payments to prevent eviction, funeral expenses, payment of college tuition, and purchase of a home. (4) early retirement: You may avoid a penalty if you retire early (but not earlier than 59.5 years) or are totally or permanently disabled and you are willing to receive annual distributions according to an IRS-approved method for a time period of no less than five years.

Retirement plans (401k/403b/457, Traditional IRA, Roth IRA), the differences between them, their tax treatment, and the penalties for taking money out early

401-k, 403-b, 457 It's your money in an employer plan. Self-directed = you decide how to invest the money Matching = the employer puts money in if you do You pay no tax on the money put in the plan or on the earnings until retirement when you draw out the money IRA = Individual Retirement Account A. Traditional = your money put in the plan is tax deductible. Available if you have no employer plan or you don't make much money. Fully taxable when you retire and draw out the money. ROTH IRA No tax deduction when you put money in the plan. Money is tax free when you retire and take money out of the plan. Traditional IRA contributions are tax-deductible on both state and federal tax returns for the year you make the contribution; withdrawals in retirement are taxed at ordinary income tax rates. Roth IRAs provide no tax break for contributions, but earnings and withdrawals are generally tax-free. taking out money early: Taxes: 20% prepaid tax plus whatever income taxes based on your marginal tax rate 10% early withdrawal penalty Loss of future earnings. Withdrawing $10,000 today could mean losing $100,000 during retirement (if 8% growth for 30 years) Tax law permits retirement at age 59 ½ Tax law requires that you begin receiving retirement income by age 70 ½ Social Security permits early retirement at age 62 with substantially reduced benefits (75% to 80% of normal benefits) Social Security permits normal retirement for most of the people in this class at age 67 Social Security pays increased benefits of 8% per year for most in this class if you delay retirement until after age 67 up to age 70. the 401(k) plan is the best-known defined-contribution plan. It is designed for employees of private corporations. You can compare the performance and expenses of your employer's 401(k) plan with others at BrightScope (www.brightscope.com). Eligible employees of nonprofit organizations (colleges, hospitals, religious organizations, and some other not-for-profit institutions) may contribute to a 403(b) plan that has the same contribution limits. Employees of state and local governments and non-church controlled tax-exempt organizations may contribute to 457 plans; only employees (not employers) make contributions to 457 plans.

portfolio

A collection of financial assets -collection of investments to meet your investment goals

Mutual funds - how they work and their advantages

A company that holds a portfolio of investment assets vs. assets that make goods or services. Investments Stocks Bonds Short-term money market instruments Other securities or assets Tax advantaged so that earnings are not taxed twice. Professional managers who make the decisions of what to invest in based on fund objectives. What kind of income can I expect from owning a mutual fund? Ordinary dividend income Capital gains Professional management Affordable investment $250 with subsequent $50 investments? Liquidity Low transaction costs Uncomplicated investment choices Easy to open account Easy to buy and sell shares Automatic reinvestment of income and capital gains Effortless establishment of retirement plans Beneficiary designation Exchange privilege Automatic investment Most investors prefer to invest in mutual funds because they provide terrific diversification, are managed by professionals, can achieve remarkable returns, and are easy to select as investments. Mutual funds also can fit just about anyone's investment goals and plans. p.468

trust

A group of corporations run by a single board of directors

will

A legally enforceable declaration of how a person wishes his or her property to be distributed after death

Roth IRA

A personal savings plan; contributions are not tax-deductible; earnings are tax-free An individual retirement account of investments made with after-tax money; the interest on such accounts is allowed to grow tax-free, and withdrawals are also tax-free.

mutual funds

A pool of money used by a company to purchase a variety of stocks, bonds or money market instruments. Provides diversification and professional management for investors. Investment company that pools funds by selling shares to investors and makes diversified investments to achieve financial goals of income or growth, or both. The mutual fund company owns the investments it makes and the mutual fund investors own the mutual fund company. Unlike corporate shareholders, holders of mutual funds have no say in running the company, although they have equity interest in the pool of assets and a residual claim on the profits.

preferred stock

A special type of stock whose owners, though not generally having a say in running the company, have a claim to profits before other stockholders do. a type of fixed-income ownership security in a corporation. Owners of a preferred stock receive a fixed dividend per share that corporations are required to distribute before any dividends are paid out to common stockholders. have a fixed income - fixed amount per share (dividends). Selling price of this stock relates to interest rates noncumulative = preferred stockholders would have no claim to previously skipped dividends

income stocks

A stock that may not grow too quickly, but year after year pays a cash dividend higher than that offered by most companies. stocks that provide investors with periodic income in the form of large dividends More dividends! Less risk. beta often less than 1.0

estate tax

A tax on the estate, or total value of the money and property, of a person who has died

stocks

A type of security that signifies ownership in a corporation and represents a claim on part of the corporation's assets and earnings.' -shares of ownership in a corporation.

P/E ratio

A valuation of a company's current share price compared to its share price earnings The current market price of a stock divided by earnings per share (EPS) over the past four quarters; used as the primary means of valuing a stock. Price of stock divided by earnings per share (EPS) One of most common ways of valuing stock. Typically between 5 and 25 Higher the P/E ratio the more speculative the stock is. Not much in dividends. Counting on the company growing/increasing in value. Use a P.E ratio to determine whether a company is cheap or expensive. high P/E ratio: -share price is high -EPS is low -more investors expect out of company low P/E ratio: -share price is low -EPS is high -people are expecting poor results to come -lower = easier it is for companies to meet expectations

net asset value

Amount that one share of a mutual fund is worth Per-share value of a mutual fund. Net asset value = (assets held - liabilities)/shares outstanding. This is the price per share.

letter of last instructions

An informal memorandum that is separate from a will and contains suggestions or recommendations for carrying out a decedent's wishes.

naked options

An option writer's position if he or she does not own the securities that he or she has agreed to sell or has not sold short the securities that he or she has agreed to buy.

bonds

Certificates of debt that carry a promise to buy back the bonds at a higher price -a debt instrument issued by an organization that promises repayment at a specific time and the right to receive regular interest payments during the life of the bond. Lending money, not purchasing ownership. Can trade them. With bonds, investors lend the issuer a certain amount of money—the principal—with two expectations: (1) they will receive regular interest payments at a fixed rate of return for many years, and (2) they will get their principal returned on a specific day in the future, called the maturity date. If an investor in bonds wanted to sell before the maturity date, he/she must recognize that the market price of the bonds is sensitive to changes in interest rates.

Large, Mid, Small Cap stocks

Classification based on company size

dividends

Company's share profits to the shareholders based on the corporation's performance.

What it means to have a diversified portfolio

Diversify! Don't put all your eggs in one basket Carry different types of investments in your "portfolio" Look at which ones are cyclical vs countercyclical Do your research!! Look at the company's value - don't just hope for the next big thing. -results in a potential rate that is lower than the potential return on a single alternative, but the return is more predictable and the risk of loss is lower. -helps control exposure to risk -seelction of different asset classes of investments that are chosen not only for their potential returns but also for their dissimilar risk-return features.

401k, 403b, 457

Employee retirement plans that are deducted from the employee's paycheck

Social security: how benefits are calculated, who is eligible, what age you are eligible, and how the system works

Generally, you must have worked at least 10 years to receive any Social Security benefits On the average, Social Security benefits are approximately 40% of pre-retirement income If your income > $32,00 married or $25,000 single per year, you may owe Federal income tax on your Social Security benefits Fully Insured Fully insured status requires 40 credits (10 years of work) and provides the worker and his or her family with eligibility for benefits under the retirement, survivors, and disability programs. Once obtained, this status cannot be lost even if the person never works again. Although it is required to receive retirement benefits, "fully insured" status does not imply that the worker will receive the maximum benefits allowable. Currently Insured To achieve currently insured status, six credits must be earned in the most recent three years. This status provides for some survivors or disability benefits but no retirement benefits. To remain eligible for these benefits, a worker must continue to earn at least six credits every three years or meet a minimum number of covered years of work established by the SSA. Transitionally Insured Transitionally insured status applies only to retired workers who reach the age of 72 without accumulating 40 credits (ten years). These people are eligible for very limited retirement benefits. Not Insured Workers younger than age 72 who have fewer than six credits of work experience are not insured. The actual dollar amount of your eventual Social Security retirement benefits will be based on the average of the highest 35 years of earnings during your working years. In these calculations, your actual earnings are first adjusted, or indexed, to account for changes in average wages since the year the earnings were received. The SSA then calculates your average monthly indexed earnings during the 35 years in which you earned the most. The agency applies a formula to these earnings to arrive at your basic retirement benefit (or primary insurance amount). This is the amount you would receive at your full-benefit retirement age—currently 67 for those born in 1960 or later. 1. Begin Receiving Benefits at Your Full-Benefit Age Once you have reached your full-benefit retirement age, you are eligible to receive your basic monthly retirement benefit. You can begin collecting these benefits even if you continue working full- or part-time. Your level of employment income will not affect your level of benefits, although it may affect the income taxes that you pay on your Social Security benefits and the amount of your Medicare premiums. 2. Begin Receiving Reduced Benefits at a Younger Age You can choose to start receiving retirement benefits as early as age 62, regardless of your full-benefit retirement age. If you do so, however, your basic retirement benefit will be permanently reduced approximately 6 percent for each year you start early. Thus, if your full-benefit retirement age is 67, your benefits could be permanently reduced by as much as .

risk vs return relationship

Greater the risk, the greater the potential return But also, the greater the risk the greater the potential loss. Total return= the income an investment generates from a combination of current income and capital gains. Capital gains = occurs when you sell an investment that has increased in value

Understand how options work - call and put options, naked and covered options

How is does a naked call work? EXAMPLE Assume you DON'T own any shares of Bank of America stock but you want to gamble on it. You could sell a "call option" on 100 shares. If the market price of Bank of America stock goes up, the owner of the call option would likely exercise the option & you would be forced to buy shares in the market. You LOSE money! If market price declines, option would expire and you would keep the premium. How is does a "put" work? EXAMPLE Assume you would like to sell 100 shares of Bank of America stock. You could buy a "put option" on that 100 shares. If the market price of Bank of America stock goes down, you would likely exercise the option to sell your shares thus MAKING more than if you sold at the market price. If market price rises, option would expire and your only cost is the premium to buy the put. How is does a covered call work? EXAMPLE Assume you own 100 shares of Bank of America stock. You could sell a "call option" on that 100 shares. If the market price of Bank of America stock goes up, the owner of the call option would likely exercise the option to buy your shares. If market price declines, option would expire.

Different types of stocks and which are more/less risky

Income stock More dividends! Less risk. beta often less than 1.0 Growth stock Some dividends, but you're hoping the value will increase. expectations for continued growth are high. P/E ratio is high; betas of 1.5 or more Blue-chip stock Been around a long time, good reputation. Relatively safe. bets are usually around 1.0. Coutercyclical stock Remains steady in an economic downturn (electric utilities, groceries, cigarettes, movies...) beta less than 1.0. Value stock Grows with the economy. Trading at a low price relative to its company fundamentals. Considered underpriced?. beta 1.0-2.0. Large, mid and small cap stock Classification based on company size (size classification is based on market capitalization) ex. large caps are firms valued at or more than 10 billion. Tech stock Technology sector Speculative stock Company with potential for substantial earnings, but those earnings may ever be realized. Genetic engineering? Oil exploration? betas above 2.0..

IRA

Individual Retirement Account - A personal qualified retirement account through which eligible individuals accumulate tax-deferred income up to a certain amount each year, depending on the person's tax bracket.

traditional IRA

Investment account that reduces current year income, and the funds in the account accumulate tax-free.

Front-end load mutual fund

Mutual funds that charge a fee at the time of purchase, which is paid to stockbrokers or other financial service advisers who execute transactions for investors. A sales charge paid when an individual buys an investment, reducing the amount available to purchase fund shares.

No-load mutual funds

Mutual funds that do not charge commissions. However, there are annual maintenance charges and service fees Funds that allow investors to purchase shares directly at the net asset value (NAV) without the addition of sales charges.

three major stock exchanges

NYSE, NASDAQ, AMEX New York Stock Exchange (NYSE): NYSE is a stock exchange based in New York. In April 2007, New York Stock Exchange merged with a European stock exchange known as Euronext to form what is currently NYSE Euronext. National Association of Securities Dealers Automated Quotation System (Nasdaq): Nasdaq is the largest electronic screen-based market. It currently offers lower listing fees than NYSE. American Stock Exchange (AMEX): Unlike Nasdaq and NYSE, AMEX focuses on Exchange Traded Funds (ETFs).

What happens in the process of distributing assets when someone dies (if they have a will, and if they don't have a will).

Nonprobate property transfers immediately upon your death, whereas the legal quagmire of probate can take between 6 months and a year, or longer if there is no will. Avoiding probate court may also save money since your estate pays the cost of the probate process based on the value of the assets it must distribute, and this ranges from hundreds to perhaps thousands of dollars. Avoiding probate additionally maintains your privacy because a public record is maintained of the probate process. Transfers with a Will Go to Your Desired Heirs A will is the smartest way to transfer your nonprobate assets upon your death. You definitely need a will unless all of your property is nonprobate property and/or will be transferred by contract When a person dies without a valid will, the deceased is assumed to have died intestate. Dying intestate can cost much more in taxes and cause legal, bureaucratic, and emotional struggles for survivors. In such a case, the probate court first ensures that the debts, income taxes, and expenses of the deceased are paid. Remember that if you did not update the beneficiaries on your 401(k), savings account or life insurance policies (what if an ex-spouse is named on everything?), the companies are obligated to send the money to those identified no matter whatever current wishes you may have. After payments are made, the probate court will divide all property and transfer assets to the legal heirs according to state law. If no surviving relatives exist, the estate will go to the state by right of escheat. Then your relatives, friends and charities will get nothing.

Price-to-rent ratio and how to calculate

Price-to-rent ratio: Price of home divided by annual rental rate 200,000/(12 x 1,000) = 16.67 13 to 1 is national average Lower price-to-rent ratio = easier to earn back your investment Michelle sees a house in the Collegedale area selling for $210,000 and is considering buying it to rent out to college students. She thinks she can rent it out for $1,200 per month. Should she buy it? 14.58 price to rent ratio = will take 14.58 years to earn back my investment. For example, a ratio of 15 means that investors are willing to pay $15 for every dollar of company earnings, for a multiple of 15. A lower ratio means that investors are paying less per dollar of company earnings, and that it will take less time for the company to earn enough to buy back its shares.

reit

Real estate investment trust - Sold like stock, offers tax benefits. Must be 75% real estate & distribute 90% of taxable income to shareholders as dividends. -can't buy real estate yourself

beta

Relative measure of risk of a stock Variation of the stocks return as compared with the variation of the stock markets return. The farther away from 1.0, the riskier Beta is a number widely used by investors to predict future stock prices. The beta value (or beta coefficient) is a measure of an investment's volatility compared with a broad market index for similar investments over time. beta of more than +1.0 to +2.0 (or higher) indicates that the price of the security is more sensitive to the market because its price moves in the same direction as the market but by a greater percentage. Higher betas mean greater risk relative to the market.

Rental yield and how to calculate

Rental Yield Estimates how much income (before mortgage payments) you'll get each year as a percentage of purchase price. Assumes ½ of rent goes toward expenses Rental yield = (Rent / 2) divided by purchase price Most yield about 4% My example: (14,400/2) / 210,000 = 3.4 %

random risk

Risk associated with any single asset; it can be reduced by holding the asset in a portfolio

blue-chip stocks

Stocks that have been around for a long time, have a well-regarded reputation, dominate its industry, and are known for being solid, relatively safe investments. stocks of large, well-established corporations with a solid record of profitability

cyclical stocks

Stocks whose success is closely linked to the rise and fall of the general economy

Which things are tax deductible on real estate used for investing

Tax Deductions Depreciation - structures (on investment properties; 27.5 yrs) Mortgage interest

business risk (non cyclical risk)

The fact that economic growth usually does not occur in a smooth and steady manner, and this impacts profits as well as investment returns. The possibility that the investment will fail to pay any return to the investor.

investment risk

The possibility that an investment will fail to pay the expected return or fail to pay a return at all

probate

The process of proving in court that the will of someone who has died is valid, and of administering the estate of a dead person. Court supervised process to transfer assets from a decedent to the heirs Public process; the will becomes a public document

escheat

The state takes property upon an owners death if there is no will & no heirs exist. the process of a decedent's assets becoming the property of the state government if no relatives can be found

Types of trusts and the differences between them (especially revocable vs irrevocable trusts)

Trust Types: Living: living trusts that take effect while the grantor is alive Revocable: A revocable living trust is used to protect and manage a person's assets. The person creating the trust maintains the right to change its terms or cancel the trust at any time, for any reason, during his or her lifetime. Irrevocable (give up ownership & control) An irrevocable living trust is an arrangement in which the grantor relinquishes ownership and control of property. Usually this involves a gift of the property to the trust. It cannot be changed or undone by the grantor during his or her lifetime. The grantor gives up three key rights under an irrevocable living trust: (1) control of the property, (2) change of the beneficiaries, and (3) change of the trustees. Because irrevocable trusts are generally considered separate tax entities, the trust pays any income taxes due. Charitable Remainder Trust (tax benefits) Effective use of an irrevocable charitable remainder trust (CRT) is popular for people who want to leave a portion of their estate to charity because doing so can boost one's income during the grantor's lifetime. You set up the trust and irrevocably give it assets. The trust then pays you income from the assets in the trust for a set period, usually for life, and possibly your spouse's life as well. The charity eventually receives the assets of the CRT when you (and your spouse, if so arranged) die. Testamentary (when you die) testamentary trust becomes effective upon the death of the grantor according to the terms of the grantor's will or a revocable living trust.

future contracts

a forward contract with standardized terms that trades on an organized exchange A zero-sum game: for every winner, there is a loser. What are commodities? A contract to actually buy (not just the opportunity to buy) a security or commodity on a future date at a price determined today This is similar to insurance to companies who actually use the products (oranges, diesel fuel, jet fuel, beef, lumber) This is a form of gambling for investors who have no use for the security or commodity.

defined benefit

a pension plan in which the benefit level is based on years of service and prior earnings; a specified amount that is guaranteed when a worker reaches a given age

trustee

a representative who votes based on what he or she thinks is best for his or her constituency

speculative risk

a situation in which either profit or loss is possible

inheritance tax

a state tax collected on the property left by a person to his or her heir(s) in a will

dividend yield

a stock's expected cash dividend divided by its current price A portion of a company's earnings that the firm pays out to its shareholders.

diversification

a strategy of increasing sales by introducing new products into new markets Process of reducing risk by spreading investment money among several different investment opportunities.

Real estate investing: the advantages and disadvantages

advantages: -Tax Deductions Depreciation - structures (on investment properties; 27.5 yrs).. land can't be depreciated Mortgage interest Favorable Tax Features Low Capital Gains Tax Rates - 15% - 20% Vacation Rental Income - Tax Free Greater of: rent fewer than 15 days a year disadvantageous:: Business risk Foreclosures in your area Illiquidity Complexity Large investment Lack of diversification Dealing with tenants Time consuming management Low income Unpredictable costs Interest rates Legal fees High transfer Costs

12b-1 fees

annual fees charged by a mutual fund to pay for marketing and distribution costs These fees are hidden and they decrease a shareholder's earning power each year without being described as a sales commission. A 12b-1 fee is actually a "perpetual sales load" because it is assessed on the initial investment as well as on reinvested dividends, every year, over long run..lower cost>

"options"

contracts that give investors the choice to buy or sell stock and other financial assets An "OPTION" is a right to buy or sell on a future day at a price determined now If you use the option to actually buy or sell, then you "EXERCISE" the option. If you don't use the option, the option will expire and become worthless.

High risk investments: what they include

derivatives collectibles options commodities precious metals

Intestate

dying without a will a person who died without making his/her own will (Every state has a standard will that is applied to decedents who fail to prepare their own will.) Will make the process longer and your money may not go where you'd like it to.

EPS

earnings per share A firm's profit divided by the number of outstanding shares.

Earnings per share and how to calculate

earnings per share A firm's profit divided by the number of outstanding shares. In our example, assume that next year, after payment of $9,000 in dividends to preferred stockholders, Running Paws had a net profit of $32,000. With 20,000 shares of stock, the company's EPS would be 1.60$ (32,000/20,000)

matching contributions

employer programs that match employees' 401(k) contributions up to a particular percentage In a contributory plan the employer may choose to make a matching contribution that may fully or partially match (up to a certain limit) the employee's contribution to his or her employer-sponsored retirement account. The matching contribution may be up to a certain dollar amount or a certain percentage of compensation. For example, the match might be $1.00 for every $1.00 the employee contributes up to the first 3 percent of pay

social security

federal program of disability and retirement benefits that covers most working people

counter cyclical stocks

generally have negative betas and move against the market. Remains steady in an economic downturn (electric utilities, groceries, cigarettes, movies...)

common stock

most basic form of ownership, become a shareholder. Have claims after bond holders and preferred stock (residual claim). Term used to describe the total amount paid in by stockholders for the shares they purchase. most basic form of ownership of a corporation or the investor, stocks represent potential income because the investor owns a piece of the future profits of the company. Investors in common stock usually have two expectations: (1) the corporation will be profitable enough that income will exceed expenses, thereby allowing the firm to pay cash dividends (2) the market price of a share of stock, which is the current price that a buyer is willing to pay a willing seller, will increase over time.

executor

person designated to execute the terms of a will

defined contribution plan

retirement plan in which the employer sets up an individual account for each employee and specifies the size of the investment into that account

market risk (cyclical risk)

risk that affects all companies in the stock market The fact that all investments are subject to occasional sharp changes in price as a result of events affecting a particular company or the overall market for similar investments.

growth stocks

stocks in corporations that reinvest their profits into the business so that it can grow Some dividends, but you're hoping the value will increase.

pension

sum of money paid to people on a regular basis after they retire

liquidity

the ease with which an asset can be converted into the economy's medium of exchange Ease with which an asset can be converted to cash.

call options

the option to buy shares of stock at a specified time in the future Stipulation in some indentures that allows issuer to repurchase the bond at par value or by paying a premium, often one year's worth of interest.

put options

the option to sell shares of stock at a specified time in the future

covered options

writer owns the optioned securities. Loss exposure is limited to the price originally paid for the securities. Occurs when an option writer who owns the covered option sells the call.