A mutual fund is a company that pools money from many investors and invests the money in securities such as stocks, bonds, and short-term debt. The combined holdings of the mutual fund are known as its portfolio. Investors buy shares in mutual funds. Each share represents an investor’s part ownership in the fund and the income it generates. Before you decide to divulge in the world of mutual funds, read below to see what common questions can come up.
How should I structure my retirement portfolio?
Your first step is to take advantage of tax-favored retirement savings tools. If you have access to a 401(k) or other employer-sponsored plan at work, participate and take full advantage of the opportunity. Open an IRA account and contribute as much as you can. Ideally, you’d be able to invest in both an employer plan and an IRA.
Contributions to employer plans like 401(k)s are typically made on a pre-tax basis, but plans may also allow you to make after-tax Roth contributions. Your pre-tax contributions reduce your current income, but those contributions, and any investment earnings, are subject to federal income tax when you withdraw them from the plan. Your Roth contributions, on the other hand, have no up-front tax benefit. But your contributions are always tax free when distributed from the plan, and any investment earnings are also tax free if your distribution is qualified. Similarly, IRAs allow a choice of either tax-deductible contributions (traditional IRA) or tax-free withdrawals (Roth IRA). Plus, funds held in an employer plan or IRA grow tax deferred. These tax features may enable you to accumulate a sizable retirement fund, depending on how well the underlying investments perform.
With that in mind, you should aim for long-term investment returns and steady growth. Many financial professionals suggest a balanced portfolio of stocks, bonds, mutual funds, and cash equivalents. The percentage of each will depend on your risk tolerance, your age, your liquidity needs, and other factors. However, the notion is fading that you should change your investment allocations and convert your entire portfolio to fixed income securities, such as bonds or CDs, by the time you retire. Instead, many professionals now advise that you continue investing for long-term growth even after you retire — especially since people are retiring younger and living longer on average. Your own personal circumstances will dictate the right mix of investments for you, and a qualified financial professional can help you make the right choices.
What is a mutual fund prospectus and how do I read it?
A mutual fund prospectus is a pamphlet or brochure that provides information about a mutual fund. Mutual fund companies must give potential investors a prospectus, free of charge, before they invest. You can get a prospectus by calling the mutual fund company directly or by visiting the fund’s website. Before investing in a mutual fund, read the prospectus thoroughly so you can carefully consider the fund’s investment objectives, risks, fees, and expenses.
The prospectus will include information about the fund manager’s objectives and practices. When reviewing a prospectus, you’ll want to look at the kind of securities the fund holds and the kind of transactions it makes and how often. Make sure the fund operates in a way that’s consistent with your own needs, investment goals, and tolerance for risk. For instance, if you need to invest for income and preservation of capital, and the prospectus describes the fund’s investment policy as aggressive and growth oriented, then you haven’t found a good match.
The prospectus will also tell you about expenses and fees. It will disclose specifics about sales charges and fees for management, distribution (12b fees), redemption, reinvestment, and exchange transactions that may be charged to you as a shareholder. It will also disclose the minimum required investment amounts and whether the fund is a load or no-load fund. Before you invest, gather this information from the prospectus so that you understand the cost of investing in the fund.
Is it better to invest in a tax-free or a taxable mutual fund?
Typically, a tax-free mutual fund is made up of municipal bonds and other government securities. Such securities are attractive to many investors because returns are tax free, often at both the state and federal levels. However, they also tend to provide lower pretax returns than comparable securities issued by nongovernmental entities. It is imperative that you consider total after-tax returns when you are comparing a tax-free fund with a taxable fund. Whether or not a taxable fund is a better choice for you will depend in large part on how much of your returns are likely to go directly to federal, state, and local taxes at the end of the year.
To determine your approximate after-tax rate of return on a taxable investment, multiply your rate of return by 100 percent minus your tax rate:
Pretax return x (100% – tax rate) = After-tax rate of return
For example, say you are in the 25 percent tax bracket and earn a pretax return of 10 percent on an investment. Your after-tax rate of return would be 7.5 percent, calculated as follows:
10% x (1 -.25) =.075 or 7.5% after-tax rate of return
In addition, consider whether the fund will be held in a qualified pension or retirement plan. If your returns will automatically accumulate tax deferred in an IRA or 401(k), there may be no reason to accept lower returns in exchange for a tax-free feature.
If you are risk averse, you may decide on a tax-free fund. The securities that it holds will be backed by the full faith and credit of the issuing bodies, be they the federal government, the state government, or a municipality. This feature coupled with the tax advantage gives some investors an added comfort level.
Disclosure:The content provided in this publication is for informational purposes only. Nothing stated is to be construed as financial or legal advice. Sterling Group United recommends that you seek the advice of a qualified financial, tax, legal, or other professional if you have questions.