Mutual Funds, IRA’s, and Roth IRA’s

As promised, today I’ll be taking a look at the different options available for 1st time young investors. Let’s start with explaining what a mutual fund has to offer.

Mutual Fund
A mutual fund is a type of investment that allows you to invest in multiple types of funds. In a single mutual fund, you can be invested in stocks, bonds, short term money markets, or other securities. Instead of having to buy a handful of individual stocks or bonds, you get multiple stocks and bonds in one package. Mutual funds are managed by a fund manager who decides which individual stocks and bonds that fund will invest in. At the end of 2007, more than $26 trillion was invested in mutual funds worldwide.

A mutual fund is not a place to make a quick dollar(although I’m sure some have found a way). It’s a long-term investment. It’s not one that you trade on a regular basis for a different fund, although it is good to re-balance your fund choices periodically. A good mutual fund will average somewhere between 7%-12% over a 5 year period. It’s possible to have a year with a -10% return, but it’s also possible to have a year where you can have a 15%-20% gain. 2008 is shaping up to be on the losing side, but you can rest assured that there will be a good year ahead in the future.

As mentioned before, each mutual fund is managed by a fund manager. And you know that the fund manager has got to be paid right? This is where mutual funds can get a little complicated. There are 2 types of ways that fees are charged - Load or No-Load. Load funds charge a commission while no-load are commission free. Within Load funds, there are Front-End load funds, and Back-End. It’s exactly what it sounds like - with front-load, you pay a percentage of the investment as a commission up front. With Back-end, you pay when you sell. Check out this chart from YahooFinance. It starts with a $10,000 balance assuming a 9% rate of return. Assuming the market reflects the assumptions made in this chart, a no-load fund is the way to go.

Total Return Comparison

	Start	Year 1	Year 2	Year 3
100% No-Load	$10,000	$10,900	$11,881	$12,950
5% Front-End Load	$ 9,500	$10,303	$11,174	$12,119
3% Back-End Load	$10,000	$10,845	$11,762	$12,374

IRA’s - Roth and Traditional (plus 401k’s)
What is an IRA? It is an Individual Retirement Arrangement (most think its Individual Retirement Account, but it’s not - but that really doesn’t matter!) It is also a tax-sheltered account. To contribute to an IRA, an individual has to have earned income during the year. To withdraw from an IRA, the individual has to be over 59 1/2, however a few exceptions do apply.

The main difference between a Roth IRA and Traditional IRA has to do with the wonderful world of TAXES!

With a traditional IRA, you do not pay taxes on the money that you contribute. Your taxable income at the end of the year is reduced by whatever money is contributed to the IRA. This means that you pay less taxes the year that you contribute.  However, when you start withdrawing the money during retirement you pay taxes on everything.

Roth IRA’s are the exact opposite. Every dollar contributed to a Roth has already been taxed. But when the time comes to start taking distributions, you do not pay any taxes.

So what’s better? I think that a Roth IRA is best, but like I said - I am no expert. There are experts though who are on both sides of the fence. In a traditional IRA, you are able to contribute more money than you could to a Roth because the money is tax free. The maximum amount you can contribute is $5,000 to a Roth, but $5,000 after tax is a lot less than $5,000 before tax. I prefer a Roth IRA because I think it is a wonderful investment tool. I also think that I am in a lower tax bracket now than I will be in 40 years. This means I pay a smaller percentage of tax. Plus, not many people see taxes being reduced in the future. You can almost bet that taxes will be raised on a consistent basis (unless someone like Mike Huckabee is president and initiates a flat-tax policy.)

A 401(k) is very similar to a traditional IRA. It is also a tax sheltered plan and all contributions are pre-tax. The difference is that a 401(k) is an employer sponsored plan. I have one of these where I work, and most larger companies will have some type of plan that you can enroll in. I contribute a certain percentage of my salary and a part of each paycheck goes straight into the 401(k). It is invested in different mutual funds. Unfortunately, sometimes companies do not give you good funds to choose from, but fortunately, I have a lot of funds to chose from through Fidelity.

So what’s best?
Although I like the Roth IRA for a variety of reasons, the best answer is to be diversified. You don’t want to have all of your eggs in 1 basket. For example, I contribute to a 401(k) through work, individual company stock of my employer, and a Roth IRA on my own. Finally, I also have a Mutual Fund that is not a tax-sheltered investment. So, I have 2 tax sheltered investments - one is pre-tax dollars and the other is after-tax. I have 2 investments that aren’t tax sheltered - stock in 1 individual company plus 1 mutual fund that is heavily invested in multiple stocks. With all of that said, diversity is the key. My strategy isn’t brain science, but it’s also not a get rich quick scheme. I have got 40 years to reach my goals. There could be better ways to go about it than I am now, but I feel confident in the path that I have chosen. At least I’m investing in something right?

Up next: detailed advice on which funds and companies are best.