Talk financial terms with your teens – Part 2
Let’s have some “funds” getting know the financial terms mutual and target funds, and traditional and Roth IRAs.
In Part 1 of this series, we covered the financial terms certificate of deposit (CD), stocks and bonds. We’ll now talk about funds and explore how you can put stocks and bonds together in collections or a portfolio to best work as a savings for retirement. Although youth may not be thinking of retirement now, they hold a great advantage if they start early. Have the conversation with them now and prepare them to be money-wise for the future. Here are some “fund” terms to consider: mutual fund, traditional IRA, Roth IRA, and target fund.
Mutual funds are just a collection of stocks and bonds that collects all the income (dividends) and loses from all the investments you have and distributes it to you. In essence, your money is spread among a variety of companies and institutions, but you put money in and take money out through the single fund. The stocks from these variety of companies can be focused on types of companies or industries. Examples of these collections can be big, small or emerging companies. The funds can also be targeted to technology, energy or emerging industries like alternative fuels and health care. There are a variety of mutual funds with lots of different combinations of these stocks and bonds. They also vary in risk and expected returns.
Managers generally collect or take a fee to manage your money or pay it to those companies that best suit the collection or funds goal. In essence, it’s a portfolio that you have someone else manage for a fee. The kicker is the fund takes a cut to manage this for you.
Traditional IRA (Individual Retirement Account). When you give a bank, broker or institution your money, they can then invest it. The longer they know they can have it, the more they invest in longer term projects. If you put money into an IRA account, you are expected to not need that money until you retire. Like a CD, an IRA uses your money to invest now in companies or government institution and make money from it. If that goes well, they give money back to you in the future with interest (hopefully).
The benefit to you is if you show you’ve saved for retirement this way (and qualify), our government adjusts your income to look lower and thus you may pay lower taxes. The government is encouraging you to save for your future by giving you a tax break. A 401(k) acts the same way. For you to save a lot now might be difficult to tackle, but what little you can will payoff well in the long run. Maybe you start by just saving the raises. You will be gaining field position each year.
Note, you don’t pay taxes on the money earned until you start to withdraw that money from the IRA or 401(k). There are however penalties for early withdrawal. There are also limits to the amount you can contribute and requirements on when you need to start to withdraw the money. See the IRS Traditional and Roth IRAs webpage for more information. The benefit to you is that the interest rate on IRAs are generally higher than a CD or savings account, and contributing to this lowers the taxes you pay during the year.
Roth IRA. Like a traditional IRA, this as a retirement savings account, but you can’t claim this on your taxes to reduce your income, thus getting a tax break now. However, if you put money towards this account, you pay taxes on the money now when rates are expected to be lower and your income is lower. When you start to withdraw the money at retirement (there is a minimum age), you don’t pay taxes on it. The benefit to you is that taxes may be higher in the future, so you are paying those now and getting tax-free withdrawals in the future.
Note, there is a limit to how much you can contribute to this account, (see IRS Roth IRAs webpage for more details), but this is something youth can benefit greatly from early on because the taxes they are paying now are generally low.
Target funds were introduced in the 1990s and are gaining popularity again in the financial field. I like to call this auto pilot investing. A target fund is often through mutual funds that will change through time to meet your needs. The change is generally from higher risk, high reward investments early on while you are younger, to less risky investments as youth get older and close to retirement. You don’t want to lose all your money at that time. Usually the investments are conservative at that time and put into companies that may give less returns, but are not as volatile.
Youth can set the “target date” for retirement and the collective agreement will adjust to meet your portfolio requirements at that time or you can adjust it as you move through life and approach retirement. The benefit is you can set it and forget it, but have a good sense of what your retirement income might be.
In Part 3 I’ll show the play cards – those pesky debit and credit cards that can cause trouble for many teens.
Other articles in series
- Talk financial terms with your teens – Part 1
- Talk financial terms with your teens – Part 3
- Talk financial terms with your teens – Part 4