If you’re like most people, you probably want to know what return you might expect before you invest. But to translate a given rate of return into actual income or growth potential, you’ll need to understand the difference between nominal return and real return, and how that difference can affect your ability to target financial goals.
Let’s say you have a certificate of deposit (CD) that’s about to expire. The yield on the new three-year CD you’re considering is 1.5%.
But that 1.5% is the CD’s nominal rate of return; it doesn’t account for inflation or taxes. If you’re taxed at the 28% federal income tax rate, roughly 0.42% of that 1.5% will be gobbled up by federal taxes on the interest. Okay, you say, that still leaves an interest rate of 1.08%; at least you’re earning something.
Sometimes you need to borrow money, especially to pay for a large purchase such as a home or a car. It’s easy to focus on your monthly loan payment, but to appreciate how much borrowing money might really cost, you also need to consider the amount of interest you’ll pay over time. The following tables illustrate the total interest paid over the life of three common types of loans that have a fixed annual interest rate and a fixed repayment term: mortgage loans, auto loans, and personal loans.
A home is often the biggest purchase you’ll ever make. Loan repayment terms vary; this chart illustrates the total interest paid over a 30-year repayment term.
Your employer-sponsored retirement savings plan is a convenient way to help you accumulate money for retirement. Using payroll deductions, you invest for the future automatically, following that oft-noted advice to “pay yourself first.” But choosing to participate is just one important step. Another key to making it work for you is managing risk in your portfolio. Following are five ways to tackle this important task.
1. Know your personal risk tolerance
Gauging your personal risk tolerance–or your ability to endure losses in your account due to swings in the market–is an important first step. All investments come with some level of risk, so it’s important to be aware of how much volatility you can comfortably withstand before choosing investments.
One way to do this is to reflect on a series of questions, such as:
- How well would you sleep at night knowing your retirement portfolio dropped 5%? 10%? 20%?
- How much time do you have until you will need the money? Typically, the longer your time horizon, the more you may be able to hold steady during short-term downturns in pursuit of longer-term goals.
- Do you have savings and investments outside of your plan, including an emergency savings account?
Your plan’s educational materials may offer worksheets and other tools to help you gauge your own risk tolerance. Such materials typically ask a series of questions similar to those above, and then generate a score based on your answers that may help you choose appropriate investments.
There’s a saying that with age comes wisdom, but this may not always be true in the financial world. As people move through different life stages, there are new opportunities–and potential pitfalls–around every corner.
In your 20s
Living beyond your means. It’s tempting to want all the latest and greatest in gadgets, entertainment, and travel, but if you can’t pay for most of your wants up front, then you need to rein in your lifestyle. If you take on too much debt–or don’t work diligently to start paying off the debt you have–it can hold you back financially for a long, long time.
Actually, there are two five-year rules you need to know about. The first five-year rule determines when you can begin receiving tax-free qualified distributions from your Roth IRA. Withdrawals from your Roth IRA–including both your contributions and any investment earnings–are completely tax and penalty free if you satisfy a five-year holding period and one of the following also applies:
- You’ve reached age 59½ by the time of the withdrawal
- The withdrawal is made due to a qualifying disability
- The withdrawal is made for first-time homebuyer expenses ($10,000 lifetime limit)
- The withdrawal is made by your beneficiary or estate after your death