Becoming Your Own Financial Advisor – Part 4


In the last article, we began exploring the various investment options that are available to you the investor for building your portfolio.

In this part, we will discuss mutual funds and IRAs as part of your portfolio options.

If you haven’t already read the first three articles in this series, you can catch up here.

IRA Basics

The individual retirement account (IRA) is a tax-advantaged savings accounts for individuals. They come with both pros and cons and it’s important before investing in one to understand both.

Some of the pros include –

  • Tax benefits
  • investments grow tax-deferred and contributions may be deductible
  • numerous investment choices with range of risk/reward characteristics.

Conversely some of the cons are

  • Early withdrawal penalties (plus income tax)
  • annual contribution limits
  • some eligibility restrictions.

You can invest in an IRA directly through a financial institution of your choice – banks, mutual fund companies and brokerage firms.

Pro Tip: If you start an IRA early and then allocate as much funding as you can, you can take advantage of the power of compounding.

The IRA is really a savings account on steroids – it has tax advantages and the glorious magic of compounding interest.

IRAs are opened by individuals – spouses have to open separate accounts.  Keep in mind that an IRA is not an investment itself -rather it’s an account where you keep investments like stocks, bonds and mutual funds.

In an IRA you choose the investments in the account and switch them up as you need or want to. IRAs come in many flavors – traditional, Roth, SEP and SIMPLE.

As long as you meet certain requirement you may have more than one type of IRA.

IRA Showdown – Traditional vs. Roth

Traditional IRAs and a Roth IRAs differ mainly on when you are required to pay taxes on your contributions.

Traditional IRAs require you to pay taxes as you withdraw the money during retirement. On the other hand in Roth IRAs, the taxes are paid as you put money into the account. Regardless of whether it’s in a traditional or Roth IRA, your money grows tax free.

Another way where the traditional IRA and Roth IRA differ is who is eligible to contribute to the IRA. Just about anyone with earned income can contribute to a traditional IRA but if you make too much income you might be prevented from contributing to a Roth IRA. Here are the IRS limits for tax year 2017

Your Filing Status Your MAGI* Allowed contribution
Married filing jointly or qualifying widow(er) < $186,000 Up to the limit
≥ $186,000 but < $196,000 A reduced amount
≥ $196,000 Zero
Married filing separately and you lived with your spouse < $10,000 A reduced amount
≥ $10,000 Zero
Single, head of household, or married filing separately and you did not live with your spouse < $118,000 Up to the limit
≥ $118,000 but < $133,000 A reduced amount
≥ $133,000 Zero

*Modified Adjusted Gross income

For the 2017 tax year, total contributions to all of your traditional and Roth IRAs can’t be more than $5,500 -$6,500 if you’re age 50+-or your taxable compensation for the year if it was less than this limit.

The last important difference is that in a Roth IRA – unlike other IRAs – there are no required minimum distributions (RMDs). If you are above the limits for a Roth contribution look here to learn about a legal way to do it. It requires one additional simple step and is referred to as the backdoor Roth IRA.

Other Variations of the IRA

Some other popular types of IRAs include

Simplified Employee Pension (SEP)

This is a type of traditional IRA that is set up by an employer for its employees.

SEPs may be an option if you are self-employed, earn freelance income or if you are a small business owner with one or more employees.

SEPs have the same general features as traditional IRAs, but allow much higher contribution limits

For the 2017 tax year, contribution limits are 25% of your compensation or $54,000, whichever is lesser.

Savings Incentive Match Plan for Employees (SIMPLE)

This is an IRA set up by a small employer for its employees. Where they differ from SEPs is that employees can contribute to SIMPLE IRAs.

For the 2017 – and 2016 – tax year salary reduction contributions can’t exceed $12,500.  In addition, employers are generally required to match this contribution on a dollar-for-dollar basis, up to 3% of the employee’s total compensation.

Spousal IRA

This type of IRA is a traditional or Roth IRA funded by a married taxpayer on behalf of a spouse with no earned income.

In the 2017 tax year you can put a maximum of $5,500 into a spousal IRA. This goes up to $6,500 if the non-working spouse is age 50+ by Dec. 31, 2017.

IRA RMDs (Required Minimum Distributions)

With IRA accounts – traditional, SEP and SIMPLE IRAs you are required to make minimum distributions (RMDs). This is just like it is with a 401k. The rule of thumb is that you must make withdrawals before April 1 of the year following the year you turn 70½.

After the initial RMD for every year thereafter you must take the RMD before Dec. 31 of that tax year. As I mentioned before, Roth IRAs are not subject to RMDs. Also, like 401ks, the amount you are required to withdraw as RMDs depends on your age, your life expectancy and your account balance.

The RMD is typically calculated by dividing the prior end-of-year balance by a distribution factor listed -by age- in IRS Publication 590, the Individual Retirement Arrangements.

There are some cases where you may end up using a different table. For instance, if your primary beneficiary is a spouse more than 10 years your junior you use the Joint Life Expectancy Table.

Mutual Fund Basics

Mutual funds are professionally managed pools of stocks, bonds with other instruments that are divided into shares and sold to investors.

Some of the pros of mutual funds include –

  • Diversification
  • Liquidity
  • Simplicity
  • Affordability – a low initial purchase
  • Professionally managed.

Some of the cons of mutual funds include

  • Fluctuating returns
  • Over-diversification
  • Taxes
  • Potentially high costs
  • Professional management is not necessarily an accurate predictor of good performance.

You invest in mutual funds directly through mutual fund companies or you can use full-service and discount brokerages, banks or insurance agents.

Like ETFs, mutual funds are also available as target-date funds. Target-date funds automatically adjust allocations based on how long you have until you retire. These types of mutual funds start out more aggressively and gradually become more conservative as your retirement approaches.

Mutual fund companies work by pooling money from different investors and then investing that money in a portfolio of stocks, bonds and other securities. With mutual funds you have professional money managers -or teams of managers –who work for you researching, selecting and monitoring the performance of the funds’ portfolios.

As an investor, you own shares of the fund, which represent a portion of the fund’s overall holdings. A mutual fund’s price is its per share net asset value (NAV) and adding any shareholder fees the fund imposes.

Many mutual funds calculate their NAV at least once daily. This is usually done after the close of the major U.S. exchanges. Mutual fund shares are redeemable – any business day you can sell your shares back to the fund.

To make money from mutual funds you have three options

  • Dividend payments: If your fund earns income in the form of dividends and interest, it will pay shareholders close to all of the income it has earned, minus any disclosed expenses.
  • Capital gains distributions: if your fund sells a security that has increased in price, it will distribute the capital gains -less any capital losses of course – to investors at the end of the year.
  • Increased NAV: When you have a higher NAV this represents an increase in value for your mutual fund investment.

You have the say so if you want to receive dividend payments and capital gains distributions. You can also choose to reinvest the money to purchase additional shares.

Of course, it goes without saying that the higher the potential returns, the higher your risk. There are several different types of funds, each with its own risk profile. Let's take a look at these.

Money market funds

Money market funds are considered lower risk than other types of mutual funds.

They are limited by law to investing in certain high-quality, short-term investments issued by the U.S. government –like Treasury bills – U.S. corporations, and state and municipal governments.

Money market returns tend to be twice what you would expect to earn in a savings account, and slightly less than a certificate of deposit (CD). These funds attempt to maintain a NAV at a stable $1.00 per share. These funds pay dividends that generally reflect short-term interest rates.

Bond funds

Bond funds are higher risk than money market funds in part because they seek to obtain higher returns.

There are many different types of bonds, and all vary greatly with their risk and reward.

Bond funds come with the same risks associated with regular bonds

  • Credit/default risk
  • Prepayment risk
  • Interest rate risk

Equity funds

Equity funds are the largest category of mutual funds and invest in stocks.

Individual equity funds use different investment strategies.

For instance growth funds, focus on stocks with the potential for large capital gains.  Income funds invest in stocks that pay regular dividends.

Equity funds have the same market risk as individual stocks. Their prices fluctuate in response to a variety of factors, including the overall strength of the economy.

Tips for Picking Mutual Funds For Your Portfolio

Here are some considerations for picking mutual funds for inclusion in your portfolio

Be aware of your diversification in relation to your time horizon and risk tolerance and look for funds that match these objectives.

For example, if you are willing to take on a fair amount of risk don’t need access to your money for a while, you could consider a long-term capital appreciation fund as part of your portfolio

Pay attention to fees. You want to opt for no-load funds, which don’t charge a front- or back-end load fee, and also look for funds with low expense ratio.

Mutual funds and IRAs are commonly used tools for investing, but at times may be misunderstood. Clarifying mutual funds and IRAs is step four in becoming your own financial advisor.

Up next in part 5:   529 Accounts

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