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Investing 101: How Does Investing Work?

Investing
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A couple sitting on the couch learning about investing 101

Depending on your long-term financial goals, simply saving money in the bank may not be enough. One way many people help increase their wealth is by investing. If you're new to investing, that can make it feel a little intimidating to get started.

How does investing work? How do you find the right investments? What are the risks? If you have any of these questions, then this guide is for you. Here are some of the most common types of investments, along with some key terms, taxes and related risks, so you can come up with an approach that matches your financial road map.

What Is Investing?

Investing is when you put your money to work for you. In other words, you put cash in some sort of asset and, if things go your way, the money you invest grows to be more in the future. But an important part of investing 101 is understanding the risk. There is always a chance you could lose money, or that your investments won't change.

The Power of Compound Interest

How does investing work to grow your wealth? One key factor is compound interest. Compound is interest on interest, or the addition of interest to the principal sum of a loan or deposit.

For example, let's say you invest $1,000 and earn 10%. In that first year, you'll make $100 and have $1,100 total in your account. If you keep earning 10%, the next year your return will be $110.

At first, your investment gains may be relatively small. But if your accounts perform well, your earnings could grow to be more than you put in. However, because past performance doesn't guarantee future results, a good year is not always followed by another one.

Types of Investments

There is a wide range of investments to explore, and each has a different level of risk and potential return. Here are some of the most common.

Stocks

When you buy stock, you are buying a small share of ownership in a company. If the company succeeds, you could benefit. First, if the company's prospects improve after your investment, the stock price could go up so you can sell your stocks in the company to another investor for more than you paid. In addition, when a company has a good year of earnings, they may make cash payments to their shareholders, which are known as dividends.

Stocks have a high potential return, but on the other hand, they can also be riskier than some other investments. You could lose money if stock prices drop and then you sell your shares.

Bonds

Bonds are like making a loan to a company or the government. You give them money, and they agree to pay you a set interest rate throughout the bond term and pay you back by the end of the contract.

Bonds can be less risky as stocks because you are promised a return: the interest rate. However, like any investment, they are not completely risk-free. If the company or government issuing the bond starts running out of money, they may not be able to make their scheduled interest payments. In a worst-case scenario, they could declare bankruptcy, and then you could lose your entire deposit.

Mutual Funds & ETFs

If you'd like help planning your investments, another option is to buy into a mutual fund or exchange-traded fund (ETF). These funds build a portfolio of stocks, bonds and other assets. The portfolio forms a shared pool of assets for a group of investors. So, when you buy in, you get a small piece of this large pie without going through the work of making each individual investment yourself.

A professional investment manager oversees the fund and updates the portfolio as necessary. A mutual fund or ETF can help make investing for beginners easier than researching their own portfolio. In exchange, the fund could charge an extra management fee.

Alternative Investments

Beyond traditional assets like stocks and bonds, there are also alternative investments. These include real estate, gold and other precious metals, hedge funds, venture capital, and commodities like oil and timber. Alternative investments have the potential to earn a high return but can also be more complex and riskier than traditional investments.

Types of Investment Accounts

Different accounts have different rules for taxes, the types of investments you can use and the amount you can put aside each year. Here are some of the most common types of account.

Brokerage Accounts

Through a brokerage account, you can buy stocks, bonds, mutual funds and other investments. You can open these accounts through a registered broker-dealer. Depending on the type of brokerage account, you may owe taxes on your investment gains each year.

Retirement Accounts

You can also invest your money through retirement accounts. The IRS places limits on how much you can save per year in certain types of retirement accounts. Most retirement plan distributions are subject to income tax and may be subject to an additional 10% tax if you take money out of these plans before you turn 59 1/2. Additional taxes and penalties may apply depending on the type of account and circumstances surrounding the withdrawal. A few of the most common retirement accounts include:

  • Traditional IRA: With a traditional individual retirement account (IRA), you put money aside for the future and pay less taxes now due to the reduction of taxable income. When you make a withdrawal, you'll pay income tax on whatever you take out. IRAs are not controlled by employers, like a 401(k) or pension, so you can open one on your own.
  • Roth IRA: With a Roth IRA, you pay taxes on your contributions as you make them. As long as you are 59 1/2 and have had the account for at least five years, your withdrawals may be tax-free, which means you may not owe income tax on your investment gains. As with other investment types, investment gains are not guaranteed, and money may actually be lost.
  • 401(k): This is a workplace retirement plan, so you can only use a 401(k) if you have one at your job. 401(k)s can come in either a traditional or Roth format for tax treatment, depending on how your employer set up the plan. You may even be able to choose your preference, or make contributions to each type.

Education Accounts

There are also investment accounts intended to save for college and other education expenses. Some of these accounts delay taxes on your investment gains, and if you spend on qualified education expenses, your withdrawals are tax-free.

One such option is a 529 plan. According to the IRS, there are no income restrictions on these plans. Although these plans are intended for college expenses, you can also spend up to $10,000 from your 529 to pay for tuition at a private elementary or high school.

Another education account is the Coverdell education savings account (ESA). The Coverdell ESA gives you more options to spend the money before college, like paying for school uniforms and room and board for a student in private elementary or high school. The downside is you can only put $2,000 a year in a Coverdell account.

Taxes on Investments

Depending on what types of investments you choose, you might owe taxes on several aspects of your assets. Here are a few things to keep in mind.

Capital Gains

When you sell an asset for more than you originally paid, you won't pay taxes on your initial investment since it's your own money being returned. Any profit is taxed as a capital gain. For example, if you bought a stock for $100 and sold it next year for $200, you would get $100 back tax-free and would owe income tax on your $100 gain.

The tax type depends on how long you owned the investment. If you held the investment for one year or less, it's a short-term gain and you'll owe your personal income tax rate on the profit. If you held the investment for more than one year, it's a long-term gain and the tax rates may be lower. The long-term capital gains rate ranges from 0% to 20% (with a few exceptions where gains are taxed at a higher rate).

Dividends

Stocks and mutual funds can pay out dividend income throughout the year. If you receive a dividend, that income is taxable that year, even if you reinvest the money to buy more stocks. The tax treatment depends on how long you owned the stock and the type of investment. In most cases you will owe the lower, long-term capital gains rate rather than personal income tax rates on dividends.

Retirement Plans

If you invest through a traditional retirement plan — whether a 401(k) or IRA — you delay the taxes on any investment gains you may have. This can increase your after-tax return, depending in part on if and how tax laws change between now and when you withdraw those contributions. Also, by waiting until retirement, you may be in a lower tax bracket and pay less taxes on the withdrawals. When you take money out of a traditional IRA or 401(k) during retirement, that's when you owe taxes, and your entire withdrawal will be taxed at your personal income tax rate.

For a Roth IRA or 401(k), you may not pay taxes on qualified withdrawals because you've already paid taxes as you made your contributions.

However, if you take money out before you turn 59 1/2, or if hold the money in the account for less than five years, the IRS will charge an extra 10% early withdrawal penalty. There are a few exceptions when you can take money out penalty-free, like to pay for college or medical bills, but otherwise your early withdrawals are penalized.

What Are the Risks of Investing?

The Securities and Exchange Commission (SEC) has identified five types of potential risks for investors:

1. Business Risk

Business risk is the chance that a company declares bankruptcy and you lose your investment. You might consider spreading your business investments across multiple companies on the chance that at least one doesn't declare bankruptcy, but this strategy still won't guarantee growth.

2. Volatility

Stocks are known for being unpredictable. If you watch the market day-to-day, prices go up and down constantly. The chance for this to negatively impact your investments is volatility risk. Consider continually evaluating your financial goals, risk tolerance and confidence in your investments to determine whether you want to sell any assets and which ones.

3. Interest Rate Risk

Some assets, such as bonds, have fixed interest rates that are locked in and do not change if rates go up. So if rates go up after you make your investment, you could have potentially earned more by waiting. For example, say you sign up for a bond paying a 6% interest rate, and then a month later, the same bond increases to a 7% interest rate.

4. Liquidity Risk

Liquidity measures how quickly you can turn an investment back into cash. Something that is liquid gives you immediate access to your savings without a loss or penalty. But not all investments offer this flexibility and some charge a penalty if you withdraw early.

5. Inflation Risk

Over time, prices for goods go up, and it costs more dollars to support the same lifestyle. This is known as inflation. If you keep your all savings in cash, you won't face investment losses but your purchasing power may go down over time.

As you get started with investing, keep this investing 101 guide handy and consider continuing your financial education by reaching out to a financial professional.

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Investors should carefully consider investment objectives, risks, charges and expenses before investing in a 529 savings plan. This and other important information is contained in the Issuers Program Description which can be obtained from a financial professional. The Program Description should be read carefully before investing.

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