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An Overview of Investing

Saving for your Investments

Tips and ideas on how to save money

An Overview of Investing - Saving for your Investments; Picture of a man saving money in a piggy bank for his future investments while using a calculator.

At first the idea of saving for your investments may seem a little odd, but the more money you can save over the years, the more money that can be allocated to your investment portfolio, thereby further increasing its value.

The additional money added to a portfolio also earns a return, giving a double bonus.

Saving Money

The average person tends to be fairly inefficient at controlling their own day to day finances. Money tends to be needlessly wasted and they are not even aware of it.

This is not their fault, it's just that they have not discovered or learnt that if they are more efficient with their finances, then their long-term investment portfolio will be given a substantial boost.

A little bit of money saved today and invested, becomes a lot of money in 20 years time.

Money saved on a regularly basis is a great way to implement dollar cost averaging, thereby providing ongoing contributions to an investment portfolio.

Saving money for your investments is surprisingly easy and it mostly comes down to simply being aware of the basic concepts. The famous investor John Templeton was a master at this in his early days of investing.

How to Save

The following list provides tips and ideas on how to help save for your investments.

Tips and ideas for saving for your investments:

  • Pay off high interest loans that are not tax deductible. Simply eliminating or at least reducing the amount of interest paid will free up cash for later on.
  • Pay off high interest loans before paying off low interest loans. It's surprising how many people will pay off the low interest loans first? Paying off the high interest loan first frees up cash that can be used to then pay off the low interest loan.
  • Pay off any personal debt before paying off any business, investment or other tax deductible debt. If you can, make the maximum repayments towards the personal debt and the minimum repayments towards the tax deductible debt.
  • Regularly place a small portion of your paycheck into a savings or cash investment account. A few dollars saved regularly adds up to lot of money over time.
  • Be cost conscious when shopping and buying items. A lot of the time the same or similar product can be purchased for less elsewhere, which is money saved.
  • Avoid impulse buying. Its amazing how many times if you do not buy something straight away, then you don't end up buying it all! Obviously you did not really need it and its money saved.
  • Take advantage of any free money that may be available, such as employee retirement plans where the employer will match the employee's contributions (up to a certain limit).

These may seem pretty obvious, but it is largely disciple and the effort an investor makes to improve their own financial efficiency.

If the investor saves a little here and there, this makes a huge difference to the investor's portfolio in the years to come.

Real Estate Investment Trusts

REITs make it easy for investors to participate in the real-estate market

An Overview of Investing - Real Estate Investment Trusts; Picture of a model house with an investors hand holding the house in their hands against the blue sky with clouds.

What are REITs

Real estate investment trusts (REITs) are companies that can be a listed company on a stock exchange or they may be a private company.

REITs invest in large-scale income producing commercial real estate such as shopping malls, corporate parks, apartments, hotels, resorts and health care facilities to name a few.

A REIT may purchase a real estate asset or it may purchase the land and develop the project themselves or through a contractor.

REITs are not considered a developer as their intention is not to resell, but rather to hold the asset in order to receive the income from renting out their premises. Thus a REIT is essentially a real estate rental company.

Easy Access to Property for Stock Investors

REITs provide the individual investor with easy access to the commercial real estate market.

REITs can be listed on a stock exchange as a public company (known as publicly traded REITs) or they can be a private company (known as non-traded REITs).

The big advantage publicly traded REITs have for stock investors is that they can simply buy shares in a REIT just like any other stock listed on a stock exchange. Thus, allowing the stock investor to further diversify their stock portfolio with commercial real estate. Even better, all the investors holdings are located in the one stock broking account.

Publicly traded REITs are relatively low risk stocks which pay dividends and can provide decent dividend yields and as such are a popular alternative to investing in utility stocks. Their capital gains potential is more subdued, but still tend to produce reasonable capital growth in line with economic growth.

Non-traded REITs are generally riskier investments even though some are registered with the U.S. Securities and Exchange Commission (SEC).

Shares in non-traded REITs are illiquid investments (they can not be easily sold) and their share prices are not frequently updated which leaves the investor with long periods of time of not knowing what their shares are worth.

In contrast, publicly traded REITs are liquid investments which can be readily bought and sold from the stock market and the investor always knows what their REITs current stock price is.

Publicly traded REIT’s can be bought and sold

on the stock exchange as easily as stocks

The dividend yields tend to be higher with non-traded REITs, but this comes with the increased risk.

Non-traded REITs may pay dividends that are higher than their net income in order to boost the yield; however this is only achievable by using debt to finance it, which reduces the value of the shares.

Shares in non-traded REITs are typically purchased through a financial adviser or broker and their up-front fees can be up to 10%, which can make non-traded REITs expensive to buy.

The cost of buying shares in a publicly traded REIT is simply the stock investor's normal brokerage charges.

In general, publicly traded REITs are the popular chose amongst stock investors as they can buy something they are already familiar with, namely stocks.

Non-traded REITs tend to be more popular with investors that do not have a stock brokerage account.

Individual Retirement Accounts (IRA)

Tax effective investing - the smart way to invest

An Overview of Investing - Individual Retirement Accounts; Picture of birds nest with three eggs inside each saying Retirement investment options basket IRA pension and 401K.

An individual retirement arrangement is a personal retirement savings account that any U.S. employee or self employed person earning a taxable income can open. These personal savings accounts are separate and in addition to any employer sponsored plans such as a 401(k).

Types of IRAs

There are two categories of individual retirement arrangements.

The first is an Individual Retirement Account (IRA) which is opened with a bank, a brokerage firm or a mutual fund company.

The second is an Individual Retirement Annuity that is available through insurance companies.

For the purpose of this article, the discussion will revolve around IRAs opened with a brokerage firm or a mutual fund.

IRAs are extremely popular and have tax advantages for stock investors who wish to build up a portfolio for their retirement. An IRA can be opened with most brokers and mutual funds.

The investor can have an IRA in addition to any employee sponsored plans. This means an employee can contribute to both at the time.

As an IRA is a personal account, the investor is entirely responsible for the management of the IRA in exactly the same way an investors manages any investment portfolio. In fact, an investor can have both an IRA and their normal brokerage account with the same broker.

IRA Requirements and Restrictions

There are some requirements and restrictions with an IRA.

IRA requirements and restrictions:

  • The account holder must be receiving an income. Also there is a maximum income limit. To be eligible to contribute, the investor's income must be below the income limit.
  • There is a cap on the maximum annual contribution.
  • Both the investor and their spouse can each have their own IRA and contribute up to their individual annual limit.
  • Contributions to an IRA can be made at any time throughout the year. This can be a lump sum or progressively.
  • IRAs are restricted to the types of investments that can be included. Generally stocks, bonds and funds (mutual, closed-end and ETF's) can be included. But margin lending, short selling and derivatives are restricted from IRAs.
  • An IRA established with a mutual fund company is generally limited to the funds provided by that mutual fund company. An IRA opened with a brokerage firm can include stocks, bonds and funds.
  • Early withdrawals attracted a penalty charge of 10% of the amount withdrawn. This is in addition to any income tax due on the withdrawal.

Investors should be aware that there are two types

of IRA accounts – Traditional and Roth

There are two main types of IRAs that can be opened with a brokerage firm or mutual fund company. They are the traditional IRA and the Roth IRA. The difference is in how the taxation is treated.

Traditional IRA

The capital gains and any interest and dividend income received in a Traditional IRA are tax-deferred. This means tax is not paid until the money is withdrawn.

There are two categories of tax-deferral: deductible and nondeductible.

If the investor is eligible, they have the option of deducting their contributions from their income. This means their income is effectively reduced by the amount of the contributions and their income tax is thereby reduced.

When the investor turns 59½ any withdrawals are considered regular income and the investor pays income tax at the applicable tax rate. Thus any tax liabilities are deferred into the future.

Eligibility for deductible contributions is determined by the investor's income and whether they are participating in an employee sponsored plan that provides deductible contributions.

If the investor is not eligible for deductible contributions, then the contributions are made with after-tax income (The contributions are nondeductible).

When the investor turns 59½ any withdrawals made are only taxed on the proportion of the withdrawal that came from capital gains, interest and dividends.

There is a limit on the maximum contribution that can be made in a year. The maximum is $5,500 for 2013 if the investor is under 50 years. The maximum for an investor 50 years or older is $6,500.

Roth IRA

Contributions to a Roth IRA are made with after-tax income, but there is no tax due on the capital gains, interest and dividends received if the account has been open for at least 5 years.

That is, the profits made in a Roth IRA are tax-free as long as the investor is at least 59½ before any withdrawals are made.

The one downside with the Roth IRA is that it has an income limit. If the investor's income exceeds the limit for that year, they cannot contribute to a Roth IRA (for 2013, the income limit is $127,000).

There is also a limit on the maximum contribution that can be made in a year. The maximum is $5,500 for 2013 if the investor is under 50 years. The maximum for an investor 50 years or older is $6,500.

IRAs provide the stock investor with options that may suit their requirements. These account types are easily opened and they do give tax advantages which is something for the investor to consider.

The money is not locked away till retirement (even though that's their purpose) and the money can be withdrawn prior to retirement, but there is a 10% penalty charge.

Target Date Retirement Funds

The portion of bonds to stocks is automatically adjusted every year

An Overview of Investing - Target Date Retirement Funds; animated Picture of a bag of money with on dollar sign on front and lots of gold coins saving for Retirement investments.

This style of fund is aimed at investors seeking a relatively easy way of investing for their retirement. They are also known as lifecycle funds and are often available as the default plan for 401(k) plans.

The Self Adjusting Mutual Fund

Target date retirement funds are essentially mutual funds aimed specifically at investors who are investing for their retirement.

The basic idea behind this fund style is that the fund invests heavily in stocks to begin with and includes only a small proportion of bonds and/or other fixed cash investments.

As the years progress, the fund increases the proportion of bonds and reduces the proportion of stocks. The idea here is to continually increase the proportion of bonds and/or cash investments as the investor approaches retirement age.

When the investor reaches retirement age, the fund may only have 30% invested in stocks and the remaining invested in fixed income assets such as bonds, treasury bills or certificates of deposit.

The reasoning behind this approach is that at retirement, the investor is now more concerned about a steady income rather than capital gains.

Target date retirement funds are generally identified by the name of the fund. An investor who is looking to retire around the year 2030, would look for a fund which includes this year in its title (such as "Retirement Fund 2030" or "Target Fund 2030").

This style of fund tends to be more popular with investors who are not managing their own retirement investments as they can leave all of the portfolio management to the fund.

However, there are numerous variations of asset mix and numerous investing strategies that target date retirement funds utilize, so the investor still needs to decide on which type to invest in.

Factors to Consider

Some of the factors to consider are;

Target date retirement funds:

  • When the target date is reached, most funds continue to reduce the proportion of stocks for a certain number of years. For some funds this might be 5 years and for another funds this might be 25 years.
  • The proportion of stocks to bonds held varies amongst funds. Some funds might be weighted 90% stocks to start with and finishes with 30% stocks. While another fund might start with 70% stocks and finishes with 20% stocks.
  • The stock investing strategies utilized varies amongst funds. Some are quite aggressive utilizing growth investing strategies, while others are more conservative and incorporate value investing and dividend investing strategies.
  • The bonds they invest in also vary amongst funds. Some will be more aggressive and invest in corporate bonds, while others are more conservative and invest in treasury bonds or they may use a mix.
  • The fund may also invest in other fixed income assets including treasury bills and certificates of deposit.

The investor thinking about investing in a Target date retirement fund needs to considerer the amount of risk they are willing to tolerate.

The different investment mixes and investing styles produce different risk levels.

Basically, the longer the investor has until they plan on retiring, then the more risk they can afford to take on as they will have time on their side. Conversely, an investor with a relatively short time frame might be more comfortable with a more conservative fund.

An Overview of Investing - Tax Considerations for Stock Investors; Picture of a road sign with yellow background and black writing saying tax caution sign for stock investors

Tax Considerations for Stock Investors

Investors often forget to take taxation into account

The discussion in this article is not intended as taxation advice, but is presented to highlight the taxation issues that the stock investor will be faced with.

Profits should have Priority over Tax

The primary focus of the stock investor should be on maximizing the profit potential of their investment portfolio.

The secondary focus should be on tax efficiency. It is generally a mistake to solely concentrate on minimizing the tax liability at the expense of maximizing the potential profit.

After all, the easiest way for an investor to reduce their tax liability is for them to reduce the returns they are achieving from their portfolio, which of course is counter productive.

While no stock investor likes the idea of having to pay tax on their investments, it is a reality of life when investing, or for that matter any venture that makes money. There are however a variety of investing strategies that make efficient use of the taxation system.

Tax on Capital Gains

The first consideration is in how the taxation system deals with capital gains.

The capital gain for an investment is referred to as an "unrealized gain" while the investment is owned. Once the investment is sold, the capital gain is then referred to as a "realized gain" and is now taxable.

This means the gain is only taxed when the investment is actually sold. If the investment is not sold, then there is no realized gain and hence there is no tax on the capital gain.

From a taxation point of view, buy and hold strategies are extremely tax efficient as there is no capital gains tax payable unless an investment is actually sold.

A capital gain is only taxed when an investment

is sold – if it’s not sold it’s not taxed

Investments that are sold and hence have a realized gain are taxed differently depending on whether they were sold within one year or not. If the investment is sold within one year, the gain is treated as income and the investor pays tax on the gain at their income tax rate.

If the investor sells the investment after one year, the gains are treated as long-term capital gains and are taxed at the lower long-term capital gains tax rate.

Tax on Dividends

The second consideration is how dividends are taxed.

Generally, for U.S. companies that pay dividends, the investor pays tax at the reduced tax rate providing that the stock was purchased at least 60-days before the ex-dividend date and held for at least 60-days after the Ex-dividend date. Otherwise the investor pays tax at their personal income tax rate.

Dividends paid by other companies, real estate investment trusts (REITs) and American depository receipts (ADRs), the investor will generally pay tax at their income tax rate.

Dividends received from foreign companies are generally subject to a withholding tax from that company's country.

This withholding tax is deducted from the dividend amount due by the foreign company which they then forward to their country's tax office.

The investor effectively receives the net dividend after the withholding tax is deducted. The investor will then pay their income tax rate on the net dividend amount received. Thus, foreign dividends are tax inefficient.

Interest payments received from bonds are generally treated as income and thereby taxed at the investor's income tax rate. Municipal bonds are an exception as they are exempted from federal taxes, but this is already reflected in the lower interest payments they pay.

An Overview of Investing - Tax Considerations for Stock Investors; Picture of a tax planning book with a black cover and silver coins on top for stock investors.

Tax and IRAs

There are various retirement accounts that stock investors can use to minimize their tax obligations. Probably the most common retirement account is the individual retirement arrangement (IRA).

There are two types, a Traditional IRA account where stock investors can defer their tax liabilities until retirement and a Roth IRA account where the investor contributes after-tax income and can make tax-free withdrawals at retirement.

These IRA accounts can be opened with most stock brokers and the investor can have an IRA account along with their normal brokerage account.

The IRA accounts do however have some restrictions.

The first restriction is that there is a maximum income limit. The investor can only contribute to an IRA account if their income is below the limit.

The second restriction is that there is a limit on how much an investor can contribute per year if they are eligible to contribute.

IRAs are a great tax efficient investment vehicle if the investor is eligible to use an IRA.

Depending on the investor's employer, they may have access to an employer sponsored plan such as a 401(k) which as a minimum tend to have mutual funds that the stock investor can contribute to.

These plans are generally very tax efficient, but they can be limited for their investment options for stock investors.

Some employers are generous and will even match the employee's contributions up to a certain limit. This certainly increases the attractiveness of contributing to such a plan.

Whatever approaches the stock investor takes to increase their tax effectiveness; this should only be a secondary consideration and maximizing the returns from their portfolio should be the investor's first consideration.