Through my work as a Certified Financial Planner™ I receive and respond to many questions throughout the course of a week. They come from clients, readers, colleagues, friends, family, and more. Some questions are general in nature while others are specific. Either way, there are still little nuggets of information that can be helpful to others. I'll be sharing these questions and answers in this series called David's Personal Finance Q&A.
Please note some of the questions have been changed around to protect the privacy of others. In addition, none of these responses should be considered investment advice. This Q&A is for educational purposes only. Please consult your own legal, tax, or financial advisor for help with your specific situation. I hope you find this helpful as you continue on your financial journey. Enjoy!
What type of investment is best for my child's education?
If you are specifically planning and saving for future college expenses, a 529 plan is built specially for this. Future withdrawals from the 529 will be tax free if they are used on qualified education expenses. In addition, while the funds are invested in the account they aren’t subject to tax either. In ordinary investment accounts, earnings like dividends and realized capital gains are subject to taxes. You should be aware that if the funds aren’t used for qualified education expenses, the amount attributable to earnings will be subject to taxes and penalties. If you are looking to save for education expenses prior to college, a Coverdell ESA may be a better fit. I write about Coverdell ESAs in more detail in the article Is A Coverdell ESA Right For You?
Why do preferred stocks have a face value and why is it different than market value?
Preferred stocks are similar in some ways to bonds. Bonds have a face value which is the amount you receive when the term is up on the bond. Preferred stocks, like bonds, trade in the open market where their value will fluctuate given market conditions. Preferred stocks react to changes in interest rates similar to the way bonds do. If interest rates rise, the value of the preferred will likely drop and the opposite should occur if rates drop. The preferred is MORE valuable if current interest rates are lower and less valuable if current interest rates are higher. This is very similar to the way bonds trade but it should be noted that other factors affect preferred stocks value as well.
Are individual bonds or bond funds a better long term investment?
Bond mutual funds will have professional management teams with experience dealing in the bond market. The fund will have a stated investment objective and managers have a responsibility (and vested interest) to make prudent investment decisions.
A lot depends on what type of bonds you’ll be investing in: high yield (junk), corporate investment grade, US government, municipals, etc. The bond market can be a murky place which is a way of saying it lacks transparency. It is nowhere near as liquid as the stock market which can make it very difficult to know whether you’re getting a fair price when you buy or sell. As a result, bond funds can navigate these murky waters better than most individual investors. The trade-off is the fee you’ll pay when investing in a bond mutual fund for the professional management of the fund. Take a look at Bond Fund Basics which goes into more detail about investing in bond funds.
Why is my entire Traditional IRA withdrawal counted as income?
When you invest in a Traditional IRA, the assumption is that you deducted the contributions from income. As a result, withdrawals from Traditional IRAs are 100% taxable as income (contributions and earnings). The rationale for this is that those funds were never taxed. If you, in fact, deducted the contributions you made, it would be correct that you would be taxed on the full withdrawal. If you didn’t deduct the contributions from your taxable income, you made a “non-deductible” IRA contribution. In this scenario, you would be taxed on the earnings. Tax-Deferred Versus Tax-Free Retirement Accounts goes into greater detail on this which you may find helpful.
Should I follow the target date portfolio for my 457 exactly as it's set up?
Target date funds are a good option if you’re not comfortable with managing your own portfolio. The portfolios adjust on their own as you get closer to retirement. One problem is that some investors may not be comfortable with the level of risk commonly associated with a long-term portfolio. A fund with a target date beyond ten years will typically have an aggressive allocation. If you have a long-term investment horizon but aren’t comfortable with an aggressive allocation, you may be in for some sleepless nights if the markets take a turn south. When you’re comfortable with the allocation and know what to expect, you should do fine with a target date fund. If you think you’ll hit the panic button with the first 10% drop in the market, a target date fund might not be the best fit for you.
If you have room in your budget to max out your 457, by all means, open the 401(k). Not everyone has access to both plans. Being able to contribute to both can be a huge advantage for those that qualify for both the 457 and 401(k).