Cracking Open Your Nest Eggs

Cracking Open Your Nest Eggs

Put all your eggs in one basket…and watch that basket.”-Mark Twain

Whether you invest on your own or have the help of a financial advisor, it is important to understand what is inside each of your “nest eggs” so you can determine how to best use each asset to fund your retirement. The line items on those bank or brokerage statements may seem a little “scrambled” at first glance, but understanding “what” you have is just as important as understanding “how much.”

An investment is anything that you purchase with the hope that it will generate income or increase in value in the future. Investments come in five basic flavors:
Stocks: which may generate income in the form of dividends or appreciate in value (capital gains)
Bonds: which primarily generate interest income, but may appreciate in value if current interest rates go down
Cash: which may generate interest income, but usually loses value to inflation
Real Estate: which may generate income in the form of rent or appreciate in value
Tangible Personal Property: which may generate income through use or rental or may appreciate in value

Stock– Stock is ownership of a part of a company. Whether it is a privately held family business or on the New York stock exchange, owning stock means that you share in the company’s success (or failure). If the company makes money it may keep it which increases the value of the company and thus the value of your share (a capital gain). Or the company may choose to distribute profits to shareholders as income (dividends). Stock can be held in the form of a certificate, in a brokerage account, or in electronic form by a holding company that accumulates dividends.

Bonds– When you purchase a bond you are loaning your money to someone at a certain rate of interest for a certain period of time. Then you get your money back. Who you loan the money to determines what “type” of bond you own.

• Corporate Bonds: loan to a company
• Savings Bonds or Treasury Notes: loan to the US government
• Foreign Bonds: loan to foreign companies or governments
• Municipal Bonds: loan to a certain municipality

How much interest you earn on a bond is determined by the current interest rates, the amount of time you are willing to wait to get your money back and the financial strength of the borrower (the likelihood of him defaulting on the loan). You may be able to sell a bond for more than you loaned if the bond is paying higher interest than the prevailing rate. Similarly, the value of bonds goes down if interest rates rise.

Cash– Cash held in the form of currency or a checking account is convenient for spending but does not generate interest. Cash also decreases in value (spending power) as inflation increases the cost of living. Thus currency or checking accounts cannot be considered true investments.

Savings accounts do generate interest as do Money Market accounts and Certificates of Deposit. The amount of interest paid on a Money Market account is tied to the stock market. A CD is tied to the length of time you are willing to commit the money to the bank. Early withdrawals of CDs are penalized.

Banks also have a variety of other assorted penalties (for bounced checks, too few or too many transactions in a month, low balances, overdrawing the account, etc.) which may end up costing much more than any interest earned.

Real Estate-Unless you plan to sell your home for a profit and live off the proceeds or rent out the upstairs, don’t consider it an investment. Your home is a consumer asset-a place for you and your family to live. The monies that you put into it are living expenses that (depending on the real estate market when you sell) you may never recover.

You may own other real estate as an investment. To determine the value of the investment you must measure the costs of keeping the property against the rental income you receive or capital gains you receive when the property is sold.

A Real Estate Investment Trust (REIT) allows you to hold real estate without becoming a land lord. The actual real estate is owned and managed by the REIT trustees. As they collect the rents, you share in the income in proportion to your share. It is similar to owning stock in a company that you don’t personally run.

Tangible Personal Property– Most of the personal property that you purchase cannot be considered an investment unless you find a way to rent it (and earn income) or choose to sell it (and earn capital gains).

My new car lost value the minute I drove it off the dealer’s lot and it became “used” instead of “new.” Each year that I drive it, it is worth less and less. My neighbor runs a limo service. His cars earn him income. My brother-in-law wants to buy a mint condition 1967 Ford Mustang Shelby which he is sure will increase in value over the years. That might be considered an investment.

The diamond that I inherited from my mother may be worth more today than it was when my great grandfather bought it for my great grandmother, but it is not an investment for me. I plan to pass it down to my own daughter rather than sell it.

Mutual Funds– Investments may be held as part of a mutual fund. A mutual fund company will hold a portfolio of investments (stocks, bonds, etc.) When you purchase a share of the mutual fund you own a part of each of those investments. Mutual funds may be targeted to particular types of investments. A mutual fund holding stock or mostly stock is called an “equity fund.” A “growth fund” concentrates on stock that generates capital gains. An “income fund” would hold mainly bonds and dividend generating stocks. Other mutual funds may be geared toward “foreign investments”, “energy sectors”, “emerging markets” or the like.

The investments held in the mutual fund, however, always consist of the five main types of investments or some combination of them.

IRAs, 401Ks, 403Bs,etc.- These tax advantaged plans are vehicles for holding investments such as stocks, bonds, etc. They can also hold groups of investments such as REITs or mutual funds. Income and growth within the IRA is tax deferred until the assets are taken out of the IRA and then al withdrawals are taxed as ordinary income.

Annuities- Annuities, like IRAs, are vehicles for holding investments which defer taxes until the assets are removed. A “qualified” annuity, like an IRA, contains money that was not taxed going in, thus 100% will be taxed coming out. A “non-qualified” annuity will only be taxed on the growth, since the original purchase price of the annuity came from assets that had already been taxed.

Knowledge is Power

If you are confused about what’s in your nest egg consider “shelling” out some money to talk to an advisor who can explain what you have and the potential benefits, risks, and costs of your investments. You should also understand the tax ramifications of your investments and estate planning techniques that can protect the value of your nest egg for you and your loved ones. That’s no “yolk.”

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