Have you heard of the new debt instrument the Treasury Department issued earlier this year? It is called the two year floating rate note. You may be wondering why the Treasury is issuing a new instrument now. The answer lies in the fact that it is still pumping money into the economy to right the ship that went off course in 2008. But what is a floating rate note and should you look into it as an option to invest your money? Here are all of the details surrounding the floating rate note.

Floating Rate Note: The Specifics

The new floating rate note (FRN) is a two year debt instrument that you can buy directly from the Treasury. Its interest rate “floats” because it changes every week when the Treasury sets the interest rates on 13 week treasury bills. This happens for two years at which point, the note matures and you get your principal back, with interest.

To purchase a floating rate note, you simply visit the Treasury website, TreasuryDirect.com. There you can buy the note in $100 increments.

Advantages of The Floating Rate Note

Of course with any investment, you have to look at both the advantages and disadvantages to know whether or not it makes sense for you to invest in the investment in question. So, let’s first look at the advantages.

Little/No Credit Risk: Since the floating rate note is backed by the U.S. government, there is virtually no credit risk. This is because the government won’t default on its debt. Of course, there is that small chance it could, but odds are, it won’t happen.

No Interest Rate Risk: Since the interest rate resets every week, there is no interest rate risk to worry about. For those of you unfamiliar with interest rate risk, it is the risk of being stuck with a low interest rate when interest rates rise.

For example, if you buy a 30 year bond that has an interest rate of 2%, there is considerable interest rate risk tied to this investment. This is because over the next 30 years, the odds are fairly great that interest rates will rise. You will be stuck holding a bond that only yields 2% while other investors are investing in bonds that are yielding more.

Added to this, you won’t be able to easily sell this bond either. After all, who is going to pay for a bond that yields 2% when they can get a bond that is yielding much more for the same price?

Short Time Frame: The note matures in two years meaning you don’t have to lock up your money for a long time. This gives investors a nice alternative to bank certificates of deposit.

Disadvantages of The Floating Rate Note

Low Interest Rate: If you’ve read any of my previous posts about investing, you know that risk and reward are related. If an investment carries a high risk, then the interest rate will be high. Think about corporations that are in jeopardy of going bankrupt and issue bonds. The interest rates can easily be 7-10% because there is a good chance the company is going to go bankrupt and you are going to lose a lot of your investment.

The same idea holds true on the flip side. If there is virtually no credit risk and no interest rate risk, how high can the interest rate really be? If you answered not high at all, you are correct. Currently, the Floating Rate Note has an interest rate of 0.09%. You can earn more at an online bank with a savings account! (Interesting fact: even with this super low interest rate, when the Treasury held the auction for these new notes, the demand was far greater than the supply. In other words, some investors don’t just look at the interest rate, but other factors as well. I’ll talk about this in greater detail below.)

The Unknown: I talk about this more below, but the assumption is that inflation and in effect, interest rates, will rise. The problem is, no one knows when this will be and as a result, you cannot “time” when you should buy the floating rate note.

Why Invest In The Floating Rate Note?

The question then becomes, why would you invest in the floating rate note at all? The answer for this question is inflation. Currently, inflation is fairly tame. But chances are it won’t be tame forever. As the economy starts to grow, so too will inflation. When inflation rises, so too will interest rates. This means that eventually the weekly resets on the floating rate note interest payments will increase, which will cause the yield to rise as well.

When will this happen? I have no idea and others have no idea either. Because of this, you can’t predict when the best time to buy will be. Sound familiar? It all comes down to what your investment goals are. For some, investing in the floating rate note now might make sense. They might favor the safety over the low interest rate. For others, it might make sense to hold out for a year or so until the economy starts to grow faster and inflation becomes a greater concern. For these people, they might need the income to live off of and as a result, cannot afford to invest in the note at current interest rates. At the end of the day, you have to refer back to you investment plan and make investing decisions based on that. Only then will you know when it makes sense, if at all, to invest in the floating rate note.

Final Thoughts

Overall, the new floating rate note is a great idea by the government. It gives investors another short-term investment product that carries virtually no risk. Of course, the cost for these great features is a super low interest rate. But as time passes, I’m sure the interest rate will rise, making this new investment choice more intriguing to investors.

More on Fixed Income Investments

• The Triple Benefit of Municipal Bonds
• Finding Alternatives to Low Interest Rates
• How to Redeem Savings Bonds
• Are Municipal Bonds the Next Bubble?
• Create CD Ladders for Short Term Money Needs
• Investment Tax: What it Means For You



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Investing in mutual funds can be a challenge when you take into account the fees that are associated with them. As time has passed, some mutual funds have become very sneaky in how they charge you fees. I say sneaky for two reasons:

• First, they will claim that the fund doesn’t charge a fee when it really charges one on the backend when you sell. The “no fee” they are talking about is one when you buy the fund.

• Second, since the fees are taken from your investment and aren’t spelled out for you on your statement, you never really know how much you are paying.

For these two reasons, you need a basic understanding of mutual fund fees. So grab a cup of coffee and take some notes. After all, it’s your hard earned money you are investing, don’t you want to know how to keep more of it?

Photo Credit: worradmu

The Basics: Load versus No Load Mutual Funds

The load vs no load concept of mutual fund investing is fairly straightforward. A no load fund does not charge you a fee to buy or sell a fund. A load mutual fund does charge you a purchase fee and/or a fee to sell. Let’s look at an example.

Fund ABC is a no load mutual fund. If you invest $1,000 all of your money goes into the investment and you have invested $1,000. Fund XYZ on the other hand is a load mutual fund. The load for the fund is 5.75%, which is fairly typical. If you invest $1,000, not all of your money is going into the investment. In fact, only $942.50 gets invested. The other $57.50 is the fee charged to you and that goes to the advisor/salesman.

In this day and age, there really isn’t any reason to invest in a mutual fund that charges you a load. When you are charged a load, you are already down 5.75% on your investment. If the market gains 5.75%, you are sitting at a 0% return on your money. Don’t fall victim to the trap that buying a loaded mutual fund is a good buy because of the fee. Many will try to get you to fall for the belief that the fund is so good, they have to charge a premium to invest in it. This isn’t the case at all. There is zero relation to a fund performing well and paying a load. None.

Early Redemption Fee

Of course, there are some other fees that you have to be aware of when investing in mutual funds. The biggest one is the early redemption fee. This is a fee you will find on many funds if you sell shares within two or three months of purchasing it. This is done so that the fund discourages people who plan on owning the fund for a short time.

For example, let’s say gold is hot right now and is only going up. Some investors might want to get into a mutual fund that invests solely in gold and then get out a month later, in the attempt to make some quick money. It might seem like there is no harm to this, but when a mutual fund has to buy and sell out of its holdings frequently, it drives the costs up for all investors. Therefore, many funds have instituted this policy to thwart short-term traders. Note that this fee goes to the fund itself and not to a salesman.

For most, this fee should not be an issue to you as you should be a long-term investor and buying and holding funds for the long haul, not for a few weeks at a time, also known as timing the market.

12b-1 Fee

One other fee to be aware of is a 12b-1 fee. More and more funds are charging this fee nowadays. It is basically a marketing fee and is usually around 0.25% annually. It gets lumped in with the management fee of the fund. Some argue this fee is OK to pay. I disagree. What does the mutual fund need to market itself for? If it does a good job and earns money consistently, others will take notice and invest in it as well. It is up to you if you are willing to pay an extra 0.25% per year for advertising. I am not one of these people.

Final Thoughts

There are all sorts of fees you can potentially pay when it comes to investing in mutual funds. I still like investing in mutual funds, but if you want a clear cut fee when investing, you should look into exchange traded funds (ETFs). There are no purchase or sales fees with these investments. For the most part, all you have to pay attention to is the management fee they charge you. For more see ETFs Versus Index Funds. But if you are mutual fund investor and plan on sticking with them as your investment of choice, do yourself a favor and pay attention to the fees that they can charge you.

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With the volatility of the stock market and low interest rates, many investors are looking for ways to earn a decent return on their money and also keep their principal safe. While it is common knowledge that you cannot earn a high return unless you take on a higher risk, you can still earn a decent return while playing it safe. To do so, look no further than municipal bonds.

3 Benefits of Municipal Bonds

Municipal bonds offer investors 3 great things: safety, income and tax benefits. But as with any investment, municipal bonds aren’t for everyone. Read on for each one of the benefits that municipal bonds offer and then you can begin to decide if there is a fit for them in your portfolio.

Municipal Bond Safety

Overall, municipal bonds offer investors safety. This isn’t to say that you cannot lose money when you invest in municipal bonds, but the odds of losing money are not high. This is due to the fact that they historically have had a very low default rate.

Of course, you can’t base all of you investment decisions on history. There are many communities in California that are bankrupt. In Michigan, Detroit recently declared bankruptcy. This means that bankruptcy and default on municipal bonds can and does happen. Before you invest in any municipal bond, make it a point to research the municipality of the bond you will be buying.

Some investors have made the mistake of thinking that municipal bonds are risk-free, meaning there is no default risk. This is not true. The only investments that are truly risk-free are US Government and Treasury bonds.

Municipal Bond Income

The next great feature of municipal bonds is the income they generate. While the income isn’t life changing, it usually ranges around 5% and is predictable.

Most all municipal bonds pay interest semi-annually. But you should be aware that many municipal bonds get called. This means that a municipality will retire a bond before it matures. For example, a municipal bond might mature in 20 years but have a call feature after 7 years. When the seventh year passes, the bond can be called by the municipality. You will receive your principal back, but you lose out on the future income payments. But, with your principal returned to you, you are free to buy other municipal bonds.

What happens when the community who issued a municipal bond defaults?
One more note about municipal bond income, in the case of a municipal bond defaulting, you will not earn the interest payments going forward as well. The municipality will simply suspend future income payments. It is rare for you to lose your principal when a municipal bond defaults.

Municipal Bond Tax Benefits

The third benefit of municipal bonds is the tax-free treatment of the income. Municipal bonds are tax-free on the federal level, meaning you won’t pay federal income tax or investment tax on the income. But, many states also offer tax-free treatment to their own municipal bonds as well. This means that if you live in Pennsylvania and buy a Pennsylvania municipal bond, you will not pay state income tax on the income either. In fact, you won’t pay local tax on it. This makes the income “triple tax-free”.

Note that not all states offer tax-free treatment on municipal bonds and that if you invest in municipal bonds from another state (for example, if you live in New York and invest in a municipal bond from Kansas), you will most likely have to pay state income tax on the income.

For many investors, the tax treatment of municipal bonds (along with the predictable income they provide) make them a wise choice for those who are retired. But, as with any investment, look into the tax treatment of the income for your state before you go out and buy any municipal bonds.

Final Thoughts

Of course, as great as municipal bonds sound, this doesn’t mean that you should rush out and buy a bunch of them. You have to determine if they fit within your investment plan. There is no point in buying something that doesn’t help you reach your goals. For example, a younger investor might not invest in municipal bonds simply because he or she needs a higher rate of return.

More on Municipal Bonds and Treasuries

• Are Municipal Bonds the Next Bubble?
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• Comparing Different Types of Treasury Securities
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• How to Lower Your Taxes on Savings Bond Interest

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In order to be a successful investor, one has to learn how to buy low and sell high. This can be hard since many of us allow for our emotions to get involved. As a result, we tend to buy high and sell low. But even when the buy low, sell high strategy is followed, there are times when it makes sense to sell low. When you strategically sell low in order to offset gains realized with other investment holdings, you apply the technique known as tax loss harvesting. Let’s walk through the various benefits of tax loss harvesting.

What is Tax Loss Harvesting?

As I mentioned above, tax loss harvesting is when you sell a security for a loss. While on the surface this doesn’t make much sense, the benefit will be clear in an example. Let’s say I have two holdings, A and B. Holding A has produced a short term capital gain distribution for me. On the surface a capital gain payout is a good thing, but the downside to short term capital gain distributions is that the payout is taxed at ordinary income levels. Therefore, if you are in the 28% tax bracket, you will be taxed at 28% on that short term capital gain.

You can offset your investment gains with your losses. However, the IRS allows you to offset up to an additional $3,000 in income each year with investment losses. If I sell a portion of Holding B for the same amount as the short term capital gain distribution of Holding A, I offset that gain with my loss and don’t incur any taxes. In essence, I just saved myself 28% since I am in the 28% tax bracket.

Benefits of Tax Loss Harvesting

1. Tax Savings.
   The first benefit of tax loss harvesting is the tax savings. Whatever amount of short term gains I can offset through selling “losers”, saves me on my taxes. Note that I don’t even need to have capital gains to save on taxes. Assume that I have no gains this year, but I sell a fund that I lost $3,000 on. I can apply that $3,000 towards my ordinary income, reducing the taxes I owe there. If I were in the 25% tax bracket, that $3,000 loss saved me $750 in taxes.
2. Carry-forward Benefit.
   Another benefit of tax loss harvesting is the carry-forward benefit. Remember how I told you that you can offset $3,000 annually? Well if you have $5,000 in losses this year, you can apply $3,000 worth of the losses this year against your taxes and the remaining $2,000 in the next year. Just because you can only offset $3,000 per year doesn’t mean you lose any additional losses. You carry that amount forward until you are able to use it. I’ve known people that have $15,000 worth of losses that they carried forward for many years.
3. Potential Higher Returns.
   Taking advantage of tax loss harvesting can allow you to realize a higher return. For example, let’s say you bought a mutual fund for $10,000 and you plan on holding it for a long time. But a few months after buying it the stock market drops and your $10,000 is only worth $7,000. You sell the fund and wait 31 days (more on the reasons for this later) and then buy back into the fund. At the end of the year, assuming you have no capital gains, you have a realized loss of $3,000 that you can write off of your taxes.

   That $3,000 is worth $750 to you if you are in the 25% tax bracket. With your reduced tax liability, you take the $750 and invest it back into your mutual fund. You then hold the fund for 10 years and it earns 7% annually for you before you sell it. After those 10 years, you have $15,375.16 as seen below:

   $7,000 + ($15,245.42-$7,000) * .85 + $750 + ($1,475.36 – $750) * .85 = $15,375.16

   Note that this assumes you are paying 15% in long term capital gains taxes. The $15,245.42 is what the $7,000 grew to in the 10 years and the $1,475.36 is what that $750 grew to. How much would you have if you didn’t sell your fund and held for the entire 10 years? You would end up with $14,458.61:

   $10,000 + ($15,245.42 – $10,000) * .85 = $14,458.61

   By taking advantage of tax loss harvesting, you earned an additional $916.55. This is all from the $750 that you were able to invest because of tax loss harvesting. If you held onto this fund for longer than 10 years, the difference would be even greater.

Notes About Tax Loss Harvesting

Wash Sale Rule. There are a few things you need to know about tax loss harvesting before you jump into it. The first is the wash sale rule. Without going into great detail, a wash sale is when you sell a mutual fund (or other investment) for a loss and buy back the same fund (or investment) within 30 days before or after the sale. If you do this, the IRS does not allow you to recognize any loss you realized on the sale of the mutual fund (or investment).

Taxable Accounts Only. Secondly, tax loss harvesting only makes sense in a taxable account. Since your retirement accounts, such as a 401(k), 403(b), Traditional IRA or Roth IRA accounts, are all tax deferred, you get no benefit of tax loss harvesting since any gains in these accounts aren’t taxed until you withdraw the money.

Final Thoughts

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• What You Need to Know About Tax Losses

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Recently, Amanda posted about using flexible CDs to access money quickly. She decided to go this route as opposed to investing in the stock market because:

I believe the stock market is going to dip again. I am not an expert by any means, but I do watch the news and quite frankly, the world economy is not looking so hot. We are not insulated from Europe’s recession and even China’s economy is beginning to slow down.

and

I have not jumped in yet because Warren Buffett says you should buy low and sell high. I feel that if we were to purchase stocks right now we would be buying high versus if we wait it out for the potential lower stock prices to purchase.

I want to look at both of these in depth because I think many others have the same fears as Amanda. I want to make it clear that I am not out to tell Amanda or others why they are wrong, I am simply trying to educate people about the stock market because there is a lot of misinformation out there. Let’s get started.

Photo Credit: worradmu

The Stock Market Is Going To Dip Again

The stock market will drop again. Hopefully, it won’t be as bad as it was in 2008. But it will drop. That is how it works. The stock market runs on a cycle, just like the economy. It has times of growth (a bull market) and times of contraction (a bear market). But you never know when this will happen.

Part of this is because the stock market is a leading indicator. Without going full-blown economics on you, economists look at leading and lagging indicators to tell when the economy is in a recession and when it is growing. Anything that tells you that the economy is going into a recession before it happens is a leading indicator. Anything that tells you after the fact is a lagging indicator.

Since the stock market is a leading indicator, one would think then that they could time the market. Unfortunately, it doesn’t work like this. Most times, we don’t put two and two together until after the fact. In other words, once we are in a recession, we see that the stock market was telling us we were heading in that direction.

So what is the point of this? The economy isn’t great, here in the United States or in other countries around the world. But that is not a reason to not invest. As I mentioned above, the market will drop. It always does. And it will rise too. It always does. You just never know when it will rise or fall. The good news is that the market rises more than it falls. If it didn’t, then it would have fallen to zero a long time ago. Therefore, the best time to invest is now.

Read More: 3 Ways to Safely Handle Stock Market Volatility

Buy Low and Sell High

This is great advice and advice I particularly follow. But here is my question: are stock prices high today? Based on 5 years ago, the answer is yes. But what about 5 years from now? Chances are that stocks prices today will be considered low when compared to the future. After all, as I just mentioned, the market rises more than it falls.

The idea of buy low and sell high is simply one based on making money – you want to sell for more than you bought for. If you aren’t planning to sell for many years in the future, then you should most certainly buy now. On the other hand, if you plan on selling in the next year or two, then you should stay out of the stock market. It’s for long-term investing, not short-term trading.

Read More: Should You Rebalance Your Portfolio or Let it Ride?

Final Thoughts

Investing in the stock market can be a dicey thing for many people. But you have to keep things in perspective. The market will fall. It always has and it always will. But it will always rise too. The stock market has never dropped to zero and I doubt it ever will. (In the rare event this would happen, the monetary system will collapse so physically money will be worthless regardless.)

You have to keep a long-term focus on the stock market. It’s not for the short-term. Invest in savings accounts and bank CDs for the short-term. For the long-term, you should be in the stock market.

I will end with a different quote from Warren Buffett in 2008, one that I personally enjoy:

“Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.”

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After the great run the stock market had in 2013, 2014 is turning into an investor’s worst nightmare. The volatility in the stock market is back, with the Dow Jones and S&P 500 declining and advancing close to 100 points daily. What is an investor to do in order to survive this emotional roller coaster ride? Below I present 3 timely tips to help you navigate the choppy investment waters safely.

Photo Credit: David Castillo Dominici

Dealing with Stock Market Volatility

1. Forget The Daily Movement and Look Long-Term
   It’s easy to get emotionally involved on a daily basis when you see the market plunging 300 points as it recently did. You best option in handling this volatility is to remember that you are in this for the long-term. Over the short-term, there are going to be bad days, but you have to remain focused on the long-term.

   An analogy I like to use is fighting with your spouse or significant other. When you get into a fight, do you decide to end the relationship because of how bad the fight was? Most likely you work through the fight. You don’t give up on the long-term relationship simply because of a short-term incident. Same thing applies to investing. Don’t be quick to pull the plug and sell your holdings. Stay focused on the long-term.

2. Reevaluate Your Goals
   When you started investing, you created an investing plan. Now is a great time to pull it back out and read through it. Why are you investing the way you are? What are your goals? Refreshing yourself with these things will help put you at ease and push through the volatile times.

   At worst, reviewing your investing goals might help you to realize that some goals aren’t goals any longer, you may now qualify for retirement catch-up contributions or you should be in a less stock heavy portfolio. Make it a point to review your investing plan so that you can feel comfortable investing the way you do.

3. Find A Hobby
   The media is all about getting a reaction out of you. In other words, they want to make you emotionally invested in the story. That is why they use headline grabbing adjectives, pictures and graphics. The more emotionally involved they can get you to be, the more you will watch. This allows them to charge more for advertisements (since more eyeballs are watching their programs) and make more money. By finding a hobby, you can more easily tune out the hype that they are selling.

   I hit the gym as my hobby or go for a run or bike ride. But anything you love to do to avoid stress is a great way to get you away from the media jamming down your throat the decline in the stock market. The less you pay attention to the hype, the less likely you are to make an emotional decision. This is a good thing since we never make good decisions when we are emotional.

Final Thoughts

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The income that investments pay investors is a great thing. Dividends are essentially free money to investors as we get “paid” for investing in certain stocks. Capital gains are a nice bonus at the end of the quarter or year that allows us to enjoy the benefits of a rising stock market or smart moves by the fund manager.

Investment Income Tax

The downside of investment income is that it is taxable. Ahh, taxes. We just can’t avoid them no matter what. Luckily, investment income is taxed at different levels and in many cases, at a lower rate than ordinary income. Below is a basic guide to how investment income is taxed. This guide won’t cover everything related to investment income and taxes 100%, so it makes sense to talk to your accountant about any of this in detail. Plus, Congress likes to change the tax code almost annually so things are always changing. With that said, I hope that this guide will give you an idea of how to invest your money smarter and in doing so, pay less taxes.

What is Ordinary Income?

Before we get into the various forms of investment income, I need to define for you what ordinary income is as I will be using that term throughout this post. Ordinary income is what the IRS deems to be income that gets taxed at the tax rates you see everywhere. So your paycheck is considered ordinary income. Likewise, some investment income is also considered ordinary income. When the term ordinary income is used, it is taxed at your income tax rate. If you are in the 25% tax bracket, then your ordinary income is taxed at 25%. Read more: How Do Tax Brackets Work?

Bond Interest and Savings Account Interest

I am lumping together these two since the income you earn from each of these investments is taxed at ordinary income levels. This means that the monthly interest you earn on your savings accounts, the interest you earn on your certificate of deposit, and the income you earn on your bonds is taxed at your current income tax rate, whichever bracket you are in.

For example, let’s say you earn $1,000 in bond interest in 2013 and are in the 25% tax bracket. In this case, $250 of your $1,000 will go to taxes.

If you invest in bonds, which you should be if you have a diversified portfolio, try to keep your taxable bond holdings in your retirement accounts. This is because your retirement accounts are “tax deferred” meaning you don’t pay taxes on the income until you take the money out. In other words, the bond income you earn can grow tax free. Note that this isn’t saying your retirement accounts should be 100% in bonds, but rather that the majority of the bonds you own should be in your retirement account to save on taxes.

Your non-taxable bond holdings, such as treasuries can be held in your taxable accounts since the interest earned on these bonds is tax free.

Dividends

As of this writing, there are two types of dividends: ordinary dividends and qualified dividends. I am not going to go into detail about the two, just know that when you receive your 1099, it will break out the dividends there for you. Another reason I am not going into detail regarding these is because almost every year, Congress debates about getting rid of qualified dividends. There is good chance the idea of qualified dividends will be history in the coming years.

Dividend tax rate: In any case, the term ordinary dividend should set a light bulb off in your head. After all, the term ordinary is in the name. As you might have guessed, ordinary dividends are taxed at your ordinary income tax rate.

Qualified dividends on the other hand, are taxed at a lower rate. As of this writing, if you are in the 10 or 15% tax brackets, you pay no tax on qualified dividends. For all other tax brackets (excluding the 39.6% bracket), qualified dividends are taxed at the 15% tax rate. If you find yourself in the highest tax bracket, 39.6%, qualified dividends are taxed at 20%.

Capital Gains

When it comes to capital gains, there are two types: short-term capital gains and long-term capital gains. Short-term capital gains are gains on investment shares you have held for less than one year while long-term capital gains are gains in investment shares you have held for more than one year.

It’s important to understand that we are talking about shares here and not the entire investment as a whole. If you owned shares in ABC mutual fund for 5 years but bought more shares in 2013, and then sold out of the investment in 2014, you could potentially have both short-term and long-term capital gains.

Capital Gains tax rate: For tax purposes, short-term capital gains are taxed at your ordinary income tax rate. Long-term capital gains have a lower tax rate. Currently, there is no tax on long-term capital gains if you are in the 10 or 15% tax brackets. The long-term capital gains rate for all other income tax brackets (except for the 39.6% bracket) is 15%. For the highest tax bracket, the long-term capital gains rate is 20%.

Capital Losses

When it comes to capital losses, there is no tax owed. Instead, you get to write-off the losses against any gains you have realized over the course of the year, with a maximum limit of $3,000. The nice part about this is that if you have losses greater than $3,000, you don’t lose the loss. You can carry it forward indefinitely.

So, if you have a capital loss of $5,000 in 2013, you can write off $3,000 of that loss for 2013. In 2014, you can write off the remaining $2,000.

3.8% Investment Tax

Investment income tax rate: Lastly, we cannot forget to mention the 3.8% Investment Income Tax that results from the implementation of The Affordable Care Act. For in-depth details about this tax, be sure to read the post I wrote about it here. But in a nutshell, taxpayers that earn more than $250,000 per year (joint filers) or $200,000 (single filers) will pay an additional 3.8% tax on capital gains and dividends.

Final Thoughts

As I mentioned earlier, this was an introductory guide to taxes and investment income. There are many more nuances to taxes and investment income and the tax law is always changing. To be safe, you should talk to your accountant about your specific situation. But this guide can be a good start when thinking about your income, investing and how to limit the amount of tax you pay to Uncle Sam each year. You can also use our tax calculator to see the impact of the various investment taxes.

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• New 2013 Investment Tax: What it Means For You

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The calculation for internal rate of return or IRR has many uses. For individuals, the most common use is to find out the rate of return our investments produce. For corporations, internal rate of return can be used to determine which project should be implemented or whether or not a stock buyback plan should be initiated. For the bulk of those reading this, you are most interested in calculating IRR for your investments, so this post will talk about this use of calculating internal rate of return.

What is Internal Rate of Return?

I will do my best to not lose anyone here, but I want to let everyone know that there is math involved in calculating IRR. Before we get to the math however, we need to have a clear understanding of what IRR is. Internal rate of return is the interest rate that will bring a series of cash flows to a net present value of zero. For example, let’s look at someone’s mortgage payment. If I took out a mortgage loan for $150,300 for 30 years, with payments of $937 each month, the internal rate of return is 6.375%.

This sounds simple enough, but internal rate of return actually gets more complicated. In order to fully understand IRR, we need to address and understand net present value as well.

Net Present Value

Net Present Value, or NPV assumes that one dollar today is worth more than one dollar tomorrow. This is because if you invest your one dollar today, you will have more than one dollar tomorrow. When looking at NPV for investments, you want the net present value to be a positive number which means you are getting a bargain. If NPV is negative, then you aren’t getting a deal.

For example, let’s say you own a restaurant and are looking to sell it for $1,000,000. I just happen to be looking to buy a restaurant so I would begin by estimating how much future cash flows your restaurant will produce into one lump-sum present value amount. If my calculations for these future cash flows total less than $1,000,000 I am not going to buy your restaurant because I will be paying more for it than I will earn back. But, if my future cash flows net present value amount is greater than $1,000,000 I would buy your restaurant.

Going back to the example above regarding a mortgage, in order to get to a new present value of zero, we see that paying the monthly cash flows of $937 for 30 years will allow us to pay off the $150,300 balance at an interest rate of 6.375%.

How to Calculate Internal Rate of Return

Now that we have a better understanding of NPV, we can go ahead and calculate IRR. Here is the basic formula for IRR:

Where:

• C = cash flows
• n = time period(s) – or years
• r = rate of return

Let’s go ahead and work on a problem now. Let’s say I buy rental property for $200,000. I plan on renting the house for $1,000 a month ($12,000 annually), and holding the house for 5 years. At that point I plan on selling the house and estimate I will get $225,000 from the sale. Here is what the formula looks like:

In order to solve for “r” we use the trial and error method (don’t worry, I’ll show you an easier way next). In order to solve for “r” we have to guess a rate of return. Let’s go with 10%. We set up the problem like this:

If we take the $200,000 as a negative since it was an outflow of cash and add back in the cash flows we would have this:

($200,000) + $10,909.09 + $9,917.36 + $9,015.78 + $8,196.16 + $147,158.40 = $14,803.26

Since the goal of NPV is to equal zero, we can see that we guessed too high since our NPV equals $14,803. If we estimate an interest rate of 8%, we have the following cash flows:

($200,000) + $11,111.11 + $10,288.07 + $9,525.98 + $8,820.36 + $161,298.20 = ($1,043.74)

We are almost at zero! If we plug in an interest rate of 8.1% our cash flows total ($210.75). For all intents and purposes, this is close enough. We won’t go our past the first decimal place, but you can if you want to.

Note that in the final year’s cash flow I took into account the sale price of the house. Be sure that you include it as well.

How to Calculate Internal Rate of Return Using Excel

The much easier and faster way for calculating internal rate of return is to use Excel. Here is how it looks all set up:

Once set up, you click on an empty cell below your numbers and click on the “fx” symbol to insert a function and search for IRR. When you find it, highlight it and click OK. Then, you click in the “Values” box and highlight your cells as seen below:

From there you can click OK – there is no need to guess. You’ll see that our answer is 8.13%, which is what we arrived at when we used the trial and error method.

Using Internal Rate of Return For Investments

When looking at other investments, you will have to pay close attention to get your true IRR. For example, let’s say you bought a mutual fund for $5,000. In year three you bought an additional $250 worth and in year six, you sold everything for $6,000. You might set up the Excel equation like this and see that you earned a 7% return.

Unfortunately, this is incorrect. Each cell is looked at as a period of time. Therefore, the correct equation looks like this:

You actually earned a 2.3% return. However, if the mutual fund paid dividends, then this too would be wrong. Let’s assume the fund paid a $50 dividend in years 1 and 2 and a $75 each year thereafter:

Your internal rate of return is 3.3%

Final Thoughts

The internal rate of return calculation can be used for many things. The key is to make sure you are setting up the calculation the right way, otherwise you are going to get a wrong answer. Because the equation for long term holdings can get cumbersome, it is best to use a program like Excel to perform the calculation for you – just make sure to include all inflows and outflows of money.

More Calculations

• How to Calculate Return on Investment
• How to Calculate Real Estate Investment Returns
• How to Calculate Annual Investment Returns
• What is the Rule of 72?

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Many people use the return on investment calculation to determine how well their investments are performing. The benefit of the return on investment (ROI) calculation is that it is very simple to understand and to complete. It is also beneficial because it gives meaning when someone tells you they earned $5,000 on an investment. But there is a downside to the return on investment calculation as well. Before we get to all of the benefits and downsides, we first need to see what the return on investment calculation looks like.

Photo Credit: Stuart Miles

Return on Investment Calculation

The equation for return on investment is straightforward. You simply take the gain from your investment, subtract the cost of the investment and divide that answer by the cost of the investment. Here is how it looks graphically:

ROI = (Gain From Investment – Cost Of Investment)/Cost Of Investment

For example, let’s say we bought a mutual fund for $5,000 and we sold it for $10,000. The equation would be:

ROI = ($10,000 – $5,000)/$5,000

The return on investment is 100%. This is clear since we doubled our money. But what if we bought $5,000 of a mutual fund, and then bought another $10,000, earned a $250 dividend and sold everything for $17,000? Here is how this would look:

ROI = ($17,250 – $15,000)/$15,000

In this case, the return on investment is 15%. Note that the gain from your dividend needs to be accounted for. Without accounting for it, you are underestimating your return on investment.

Read More: Should You Reinvest Dividends?

Pitfalls To Watch For

The biggest pitfall with the return on investment calculation is that many times people omit important information, which therefore gives them an incorrect answer. The dividend example about is just one of these pitfalls. Others include:

Transaction Costs: If you are being charged to buy a stock by an online broker, that charge needs to be included in your costs.

Dividends & Capital Gains: I mentioned dividends above, but don’t forget about capital gains as well. Both of these need to be added to your gain when computing return on investment.

Home ownership Costs: Many times, whether it is homeowners or rental property owners, people forget to include ongoing costs associated with the house which include insurance, taxes, upgrades, etc. All of these need to be included in the cost of the home. It would be inaccurate if you sold your house for $250,000 which included the appreciation of your remodeled kitchen but you never included the cost of the remodeled kitchen in your costs.

Read More: 3 Steps to Successful Investing.

Benefits Of Return on Investment

The greatest benefit from return on investment is that it tells us exactly how profitable an investment was. For example, let’s say you have two friends, Bill and Sarah and Bill tells you he just made $5,000 selling his collectibles and Sarah tells you she just made $1,000 on a stock. Just looking at these numbers, you would think that Bill’s investment in collectibles is a better one because he earned more cash. The problem is that we don’t know the costs associated with each.

When we look at the return on investment, we see that Bill sold his collectibles for $60,000 but his cost was $55,000. He made $5,000 and his return on investment was 9%. But Sarah sold her stock for $10,000 after buying it for $9,000 making her return on investment 11%. Even though Bill has more cash on hand, Sarah’s investment was the better investment in terms of return on investment.

Read More: Should You Rebalance Your Portfolio or Let it Ride?

Downside Of Return on Investment

In the beginning of this post I mentioned that the return on investment calculation has a downside. That downside is time. The return on investment calculation does not take into account time. This makes a big difference. For example, assume Bill and Sarah are back and they have a hot new investment for you take part in. Bill’s will return 100% and Sarah’s will return 65%. On the surface, Bill’s looks like the winner. But what if you have to wait 10 years to earn Bill’s return and Sarah’s investment will pay you back in 3 years? Here, Sarah’s investment is superior.

Read More: Why You Aren’t Earning What Your Mutual Fund Says You Are.

Final Thoughts

The return on investment calculation is an easy one to perform. Just be certain that you include all of your costs and of your gains in the equation so that you have an accurate answer. Also, remember to be aware of time as well. If it is going to take years for you to realize the gain on one of your investments, then the compound annual growth rate calculation will provide a far more realistic picture of your return on investment as opposed to the basic return on investment equation presented here.

More Calculations

• What is the Rule of 72?
• How to Calculate Real Estate Investment Returns
• 4 Ratios to See How You Stack Up Financially
• How to Calculate Annual Investment Returns

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A search online asking the question “should I pay off debt or invest” is going to yield thousands of results, each with their own opinion on what is the best choice. (OK, I just googled it and there are over 26 million results.) Sadly, if you look at them all, you will not come to a consensus on which is the better choice.

Photo Credit: Stuart Miles

Should You Pay Off Debt or Invest?

For what it is worth, I personally feel that for the majority of people, they are better off paying down their debt. The reason I say this is because while we all may have good intentions, taking money each month and investing it in the stock market, many of us will never do that. We will find other things to do with that money, like buy something or go on a vacation. For this reason, I suggest you are better off paying down debt. But keep reading…

Looking Through a Different Lens: Paying Off Debt is Investing

However, depending on how you define the term investing, you very well might be better off “investing”. When you think about investing, you are putting your money in an asset that you believe will grow over time.

If we instead define investing as putting ourselves in better financial shape, we can invest by paying off debt. I’m sure most of you have heard the line that if you have a credit card charging you 18% interest, you should pay it off to realize an 18% return on your money. While you are not technically earning 18%, you are saving 18% of your money because you won’t be paying the interest to the credit card company.

This is essentially investing. You are investing in your debt. Whatever your interest rate is on your debts, by paying it off, you are receiving that interest rate back as savings.

How to Prioritize Your Investments

So going forward, don’t ask whether you should invest or pay off debt. It’s not an either or situation. The only option is to invest your money. You now just have to decide how to invest it. Here is the new process:

• Decide to “invest” your money.
• Create a spreadsheet with all of your debts along with their interest rates.
• Include a list of potential investments, along with their expected returns. For stocks, assume 7%, bonds, assume 4%.
• Re-arrange everything on the list so that the items with the highest interest rates/expected returns appear on top and the lowest interest rates/expected returns appear on bottom.
• Invest in the first item on the list and work your way down.

Real Life Example

Let’s say I have a credit card with 18% interest, a student loan at 7%, a 4% mortgage and I want to invest in stocks, which return 7%. I would list them as follows:

1. Credit Card: 18%
2. Student Loan: 7%
3. Stocks: 7%
4. Mortgage: 4%

I would invest in the credit card first, followed by the student loan, and then stocks. All the while, I will continue to make my monthly payment on my mortgage. It’s as easy as that. For those of you reading this that want to take into account taxes on debts such as student loan interest and mortgage interest deductions, you can get more detailed with your investing analysis. For most people however, that is too much detail for them.

It is more important to get in the habit of investing rather than get bogged down with the details. (Note that I am not trying to make is sound like the details are not important, because they are. However, considering the abysmal savings rate this country has, just getting in the habit of saving is more important at this point than trying to figure out if stocks will yield 1% more than student loans after-taxes.)

Final Thoughts

As I alluded to above, it is important that you first get in the habit of saving. By paying of debt, you are learning to budget an amount of money each month to meet a goal. Once your invested all of your money into paying off high interest debt, you can then begin to earmark that money for investing in assets that will grow over time. Are You Focused on Today or Tomorrow?

When we ask the question, “should I invest or pay off debt” we get a case of analysis paralysis because there is so much conflicting information. I suggest you eliminate that step by making everything an investment. You are going to invest you money, whether it be in your debt or in new assets. Either way, you are setting yourself up on a course to reach your financial goals.

More “Should You” Questions

• Should You Liquidate Savings to Pay off Debt?
• Should You Pay Your Student Loans with a Credit Card?
• How Big Should Your Emergency Fund Be?
• What Should Your Financial Pie Chart Look Like?
• Should You Save for College or Retirement First?

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