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Investment advisor Nancy Dunnan, author of Never Call Your Broker on Monday: And 300 Other Financial Lessons You Can’t Afford Not To Know (1997), answers a range of questions on investing in stocks, bonds, and money market mutual funds, and on other investment opportunities. Dunnan answers fundamental questions for beginning investors who want to know the difference between a stock and a bond and how to start saving for a college education. But she also tackles more advanced questions, such as how to invest in foreign stock markets, what is a zero-coupon bond, and how feasible is it to get in on an initial public offering (IPO).
Q: We are tired of living paycheck to paycheck and would like to start investing. We only have a tiny amount of money to start and wonder what’s the best way to get our feet wet.
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A: First of all, congratulations on realizing the importance of starting to invest. Don’t worry about not having a fortune—the dollar amount is not at all important, but the habit of saving definitely is.
I don’t know how much money you have to start with. Most mutual funds have opening minimums of $1,000 to $5,000. However, there’s a wonderful way around these minimums that sounds right for you. If you sign up for a fund’s automatic investment plan, you can open an account for much less.
Q: What are the different types of bonds?
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A: Bonds, which are issued to raise money, fall into three basic categories:
(1) Those issued by the United States government (primarily the Treasury Department) and its agencies. The U.S. Treasury sells Treasury bills, notes, and bonds, as well as U.S. Savings Bonds. T-bills mature in 1 year or less; T-notes mature in 1 to 10 years; T-bonds mature in 10 to 30 years. Interest earned on Treasuries and savings bonds is exempt from state and local taxes. Savings bonds used to pay for college expenses may also be exempt from federal taxes for some investors.
(2) Those issued by corporations, such as IBM or GE. The interest earned on corporate bonds is generally higher than on Treasuries. However, interest on corporate bonds is fully taxed.
(3) Those issued by states, towns, or municipalities, known as munis. The interest earned on munis is exempt from federal income tax and, if the bonds are issued in the investor’s state of residence, exempt from state and local income taxes.
Q: Why would a company want to issue bonds rather than issue equities? What are the pros and cons of each?
A: The decision about equity (stock) vs. debt (bond) financing largely lies with a company’s chief financial officer (CFO). Typically, the CFO is charged with finding the optimal balance between the two types of financing, although the decision is obviously with other executives.
The decision is always complex and depends on many variables. Here is an overall look at the topic. Please realize we haven’t covered absolutely everything.
To determine what the ‘optimal’ balance is, the CFO looks at the company’s overall business risk and possible changes in the economic environment. Because companies within the same industry, by and large, have similar business risks, entire industries often adopt similar types of financing.
Two of the most important elements of business risk are (1) sales volatility and (2) operating leverage. Operating leverage is the extent to which a company’s costs of operating are fixed. Fixed expenses include rent, insurance and executive salaries. Variable expenses are such items as materials, direct labor, advertising. In a relatively automated company where many costs are fixed, every dollar of increase in sales is a dollar of increase in operating income, once the break-even point has been reached.
Both sales volatility and operating leverage affect how much cash a company has—cash that is needed to service its debt, that is, to make regular interest payments to bondholders and eventually, to make the bond maturity payments.
The rule of thumb is: the more volatile a company’s sales and the higher its operating leverage, the lower its debt level should be. With companies in industries where sales are not necessarily consistent, such as the retail, auto and construction industries, the cash flow is obviously less during sluggish times. That means less cash available to pay bondholders. This can be a serious problem during an economic slowdown.
On the other hand, companies in industries where sales fluctuate only modestly, such as the utilities industry, can afford to comfortably handle a higher level of debt.
Another consideration in determining which way to go—to issue stocks or bonds—relates to taxes, with bonds coming out on top.
Coupon payments to bondholders are made with pretax dollars while dividend payments to stockholders are made from after-tax income. Because Uncle Sam picks up part of the cost of debt service, the cost of issuing bonds is dramatically reduced vis a vis issuing stocks.
In fact, the higher the tax rate the greater the benefit provided by Uncle Sam. For example, a company in the 40 percent marginal federal-plus-state tax rate that issues debt at 6 percent would have a ‘cost of debt’ of only 3.6 percent].
So, as you can see, debt financing is generally less expensive than equity financing.
Another reason in favor of bonds is that bonds let management raise money but at the same time maintain control of the company. When you own stock in a company, even one share, you are a part owner and have voting rights and a say in the management of the firm. The more tightly controlled the firm, generally the greater the predisposition on the part of management to finance using bonds.
As you can see, the optimal capital structure for a corporation is not so clear-cut. It involves complicated and challenging decisions based primarily upon the business risks and partly on tax issues. I think you could say it’s partly art, partly science.
Q: What is day trading?
A: A day trader is not an investor but rather someone who holds a stock for a very short time, from just minutes to hours. He or she makes a number of trades each day and closes out most or all within the same day. In fact, a true day trader does not own any stocks overnight!
The Securities and Exchange Commission (SEC) defines day traders as people who buy and sell stocks throughout the day “in the hope that their stocks will continue climbing or falling in value for the seconds to minutes they own the stock, allowing them to lock in quick profits.”
Many day traders buy on borrowed money. They then sit in front of computer screens, searching for a stock that’s moving up or down in price so they can ride the momentum and sell the stock before it changes direction.
Day trading is not illegal, but it is clearly very risky. As SEC Chairman Arthur Levitt told the United States Senate, “Most individual investors do not have the wealth, the time, or the temperament to make money and sustain the devastating losses that day trading can bring.”
If you’re thinking of giving up your day job to become a day trader, read the precautions given by the SEC. Then, if you decide to proceed, make certain you’re doing business with a legitimate firm—one that has registered with the SEC and with the states in which it does business. Check with your state securities regulator and, at the same time, ask if the firm has any history of problems. The North American Securities Administrators Association has the numbers for all state securities regulators.
Q: What are dividends?
A: A dividend is a distribution made by a company to its shareholders. The dollar amount of the dividend, which is determined by the board of directors, is taken from earnings and profits. Most dividends are paid every three months.
Companies are not required to pay dividends. In fact, small, fast-growing companies usually decide to keep any profits in order to finance their growth. Larger companies, on the other hand, often elect to return a portion of earnings to shareholders.
If business is poor, it is not uncommon for a company to reduce or even eliminate dividends. On the other hand, if business is booming, management may decide to increase dividends. A dividend increase is usually viewed as a positive, an indication that the corporation is confident about its future. Once a dividend is declared, often the stock will rise in price.
Q: How is the Dow Jones Industrial Average calculated?
A: The DJIA, or Dow, consists of 30 large blue-chip stocks regarded as leaders in their industries and widely held by both individual and institutional investors. The stocks are selected by editors at the Wall Street Journal. (There are no transportation or utility companies in the DJIA because each of these groups is tracked in a separate Dow Jones average.) The Dow is computed at the end of each day that the market is open by adding the stock prices of these 30 major industrial companies and dividing by a divisor. The divisor, which is listed in the Wall Street Journal, is adjusted to accommodate various changes, primarily stock splits. The Dow is price-weighted, which means that higher-priced stocks have greater weight on the average than lower-priced stocks. Thus, a major price fluctuation in just one or two high-priced stocks can exert a strong influence on the Dow.
Q: How do I open an education account? How much can I contribute yearly and what are the restrictions, if any, on how the money is used?
A: Feeding and clothing children is pretty expensive, but nothing compared with educating them. That’s why you’re smart to open an education account.
The Education IRA is a special, tax-advantaged savings or investment account that can be opened for any child who is 18 or younger. In fact, it can be opened for a day-old baby, provided you have the baby’s Social Security number.
During 2001 you can contribute up to $500 per child to the account (only one account per child). The child, of course, must be named as the beneficiary. The account can be opened with most mutual funds, brokerage firms, and banks.
Incidentally, grandparents, aunts, uncles, and any other people who love your child can also contribute to the account—just as long as the total from everyone is not above $500 per child this year.
So encourage friends and relatives to put money into an Education IRA rather than give your child yet more toys, games, CDs, and clothes. (Most kids have plenty of things to play with and clothes to wear.)
Caution: Your rich relatives may not be able to participate. The IRS rule is that each person who contributes (including you) must fall within certain income guidelines.
If you contributed $500 to the account from the baby’s first year and it earned 5 percent annually, there would be $13,500 available when the child graduated from high school.
Well, $13,500 is nice but not overwhelmingly nice, especially when you consider that the average cost of one year of college (tuition, room and board, fees, and books) at a public institution is $9,635. At an Ivy League school, the average hits $33,000.
The new Economic Growth and Tax Relief Reconciliation Act of 2001, recently signed by President George W. Bush, has made the Education IRA a whole lot more helpful. Here’s why:
(1) The maximum contribution starting in 2002 will be $2,000 per child per year—a nice leap forward from $500.
(2) The adjusted gross income (AGI) ceiling of contributors has been raised so that more Americans can fund these accounts. For example, if you are a single parent and your income is $110,000 or less, you qualify to open and/or contribute to an Education IRA. But if your income as a single parent is between $95,000 and $110,000 you can only make a partial contribution, not the full $500. In other words, the contribution amount phases out between these AGI parameters and ends at $110,000.
If you are married and file a joint return, contributions for this year start to phase out when your AGI is between $150,000 and $160,000. However, the income limit for married couples has been increased for 2002. It will start to phase at $190,000 and end at $220,000.
(3) Starting in 2002, you can use the money in the account to pay for more than just college expenses. (In the past, funds were only available for college costs.) Next year, you can also use the money to pay for education expenses for kids in kindergarten through 12th grade.
Among the expenses that qualify for elementary, junior high, and senior high school kids:
Tuition at private and parochial schools
Room and board
Fees
Academic tutoring
Books
Supplies
Equipment
Uniforms
Transportation required by a public, private, or religious school
In addition, computers and peripheral equipment, software, and even Internet access will also be counted as eligible expenses for elementary and secondary school children. However, software for sports, games, and hobbies doesn’t make the cut!
(4) The deadline for making contributions has been extended from December 31 to April 15 of the following year.
Sadly, the contribution made by you or anyone else to your child’s Education IRA is not tax deductible. However, the earnings in the account do grow tax free and withdrawals are also tax free as long as the money is used to pay for 'qualified' educational expenses, as explained above.
You should also consider these two facts: (1) You can transfer assets in the account to another child in the family if the first child does not use them, and (2) the money can be used tax free until the beneficiary turns 30—so that means it’s good for qualified graduate school expenses.
Q: Do I need to be a millionaire to take advantage of IPOs?
A: Well, it does help to be a millionaire—for getting in on initial public offerings (IPOs) and lots of other things too. Why? Because unless you have a connection or are a very good customer at the right brokerage firm at the right time, participating in an initial public offering (IPO) is next to impossible. Underwriters tend to favor institutional clients, and the individual investor is generally shut out.
However, you could participate through a mutual fund—but let me offer a word of caution first. The world of IPOs is full of risk, and you must be realistic and aware that it’s not a given you’ll make a fortune.
Q: What is insider trading?
A: This phrase has two meanings: One describes illegal conduct, the other a legal process. Let’s start with the illegal one first.
Illegal insider trading refers to people who use inside (nonpublic) information to buy or sell a company’s stock. This typically applies to transactions by people who have confidential information because they work for the company. People who are tipped off by an insider—such as friends, business associates, and family members—can also be prosecuted if they trade the stock after receiving nonpublic information.
In 1997 the Supreme Court broadened that meaning of “insider.” It now includes people who don’t work for a company but who use confidential information about the company—frequently its secret takeover plans—to reap profits by buying stock. This landmark case involved a lawyer who made more than $4.3 million by trading in Pillsbury stock after he learned that a client of his law firm (Grand Metropolitan PLC) was planning a takeover bid of Pillsbury. Therefore, government employees, as well as employees of law, banking, brokerage, and printing firms, are also at risk.
The legal use of the term refers to corporate insiders—officers, directors, employees, and family members—who trade securities in their own companies. Any person or trust that owns 10 percent or more of a company’s stock is considered an insider. All trading by these insiders must be filed with the SEC. (Insider trading filings are made available to the public online.)
Many experts believe that purchase of a company’s stock by insiders is a positive sign, reflecting the belief that the company will do well. Sale by an insider is less clear—the person may be selling to raise money for personal reasons and not necessarily because he or she feels the company is headed for trouble.
Q: Are there any risk-free investments?
A: No, because even the safest investments, such as bank savings accounts, come with the risk of bank failure or the risk of not earning enough interest to keep up with the rate of inflation. But some investments are much safer than others. FDIC-insured bank savings accounts and bank certificates of deposit (known as CDs) are protected up to $100,000. Mutual fund money market accounts, although not insured, are also safe and pay higher rates than bank accounts. Investments backed by the U.S. government, such as EE Savings Bonds; I Bonds; and Treasury bills, notes, and bonds are regarded as extremely safe. However, if you are forced to sell Treasuries prior to maturity, there’s always a chance they may have dropped in price. And, if you cash savings bonds in before you’ve owned them five years, they are assessed a three-month interest penalty.
Q: I’m going to have my second child in a few months and would like to open an account for the baby. Where is a good place to put money so that it won’t be taxed? Is a Uniform Gift to Minors a good place?
A: You are so smart to start planning for your baby’s future now! To get started, open an Education IRA. In that type of account, money grows tax-deferred and—if used for eligible education expenses at a public or private school—is tax-free when withdrawn.
In contrast, stocks, bonds, and cash deposited in a Uniform Gifts to Minors account are held in a custodial account until the child turns 18 or 21 (depending on the state in which you live). At that point, the money belongs to the child and he or she can use it for anything—for college, to buy a BMW, to travel around the world. As a parent, you no longer have control over the assets.
Money in a custodial account is taxed in a number of ways. In 2001, if a child was under age 14:
1. The first $750 of investment income is tax-free.
2. The next $750 is taxed at the child’s rate.
3. Amounts over $1,500 are taxed at the parent’s rate.
When the child turns 14, however, the income from the account is taxed at the child’s lower rate, which most likely will be 15 percent.
Therefore, a Uniform Gifts to Minors account does not meet your request for a tax-free savings plan.
Another option, state tuition plans, also known as Section 529 Plans, were made more appealing by new tax legislation passed in 2001. Starting in 2002, all withdrawals for eligible college costs will be tax-free. (Previously, your child had to pay tax on money that was withdrawn.)
These plans come in two flavors: Prepaid Tuition Plans and Savings Plans.
1. Prepaid plans, which are offered in most states, enable parents to lock in today’s tuition rate. That way, if college tuition rises, you won’t have to come up with more money. Contribution limits vary from state to state.
2. Savings plans are basically investment programs. However, you probably won’t be the one picking the investments. Most state programs use a professional money manager who combines your contributions with those of hundreds of other parents and invests them in a wide range of securities. This plan does not lock in tuition costs.
Anyone can contribute to a Section 529 Plan for the benefit of a child. You do not have to be related to the child. Although the contribution is not deductible from your federal taxes, a number of states allow you to deduct your contribution from your state income tax.
Unlike the Education IRA, there are no income limits on who can contribute to Section 529 Plans. And while Education IRAs have limits on how much you can contribute per year per child, these 529 plans have much higher limits—some allow contributions up to $100,000 a year without triggering a gift tax.
The College Savings Plans Network Web site provides links to the official sites for all state 529 plans. In the FAQ section, the difference between state prepaid and state savings plans is further explained. You’ll also find information on the various tax breaks involved, what happens if your child doesn’t go to college, and other pros and cons.
Q. Should I take any special precautions before investing in overseas securities? I am interested in investing in the Japanese stock market while the Nikkei is low.
A: A very wise question. One should always be careful investing, but especially with foreign stocks and bonds. As you probably know, investing in overseas securities always entails currency risk. That’s a given.
A less well-known risk involves public disclosure. In the United States, the Securities and Exchange Commission (SEC) requires companies to publicly report their earnings, losses, dividend increases or decreases, changes in management, and a host of other financial details. Foreign countries tend to be less stringent, and getting these details can be very difficult, if not impossible.
Therefore, I strongly recommend that you buy American Depositary Receipts (ADRs) of Japanese stocks. They will provide you with some degree of protection.
An ADR is a receipt representing shares of a publicly traded foreign company—shares that have been placed with a custodian bank. Once the shares are with the custodian bank, such as Citibank, the Bank of New York, or J. P. Morgan, that bank issues depositary receipts. These receipts, backed by the foreign shares on deposit, trade in the United States like other securities.
ADRs can be listed on any of the U.S. stock exchanges, including the NYSE, the AMEX, and the Nasdaq.
Each ADR is backed by a specific number (or a fraction) of shares of the foreign company. This number, set by the depositary bank, aims to set the ADR price so it’s comparable to that of shares of U.S. securities in the same industry.
(1) ADRs enable you to invest in an efficient way—certainly much more efficiently than you could if you went directly to a foreign stock market. You don’t have to jump over the various hurdles that come with direct international investing.
(2) Because ADRs are traded as U.S. securities, they are covered by our securities regulations, with the SEC overseeing their public disclosure.
(3) The price for an ADR is always quoted in U.S. dollars.
(4) Any dividends or distributions are converted into dollars at competitive foreign exchange rates.
(5) The information you receive, including proxy material, is written in English.
There are more than 1,500 ADRs, representing 50 to 60 countries. One of the most complete lists is on the Bank of New York’s Web site. Once at the site, click on 'Company Profiles' and then 'Asia.' Scroll down until you reach 'Japan.' You can then click on the company profile for each of the Japanese stocks listed there, such as Crayfish, Kobe Steel, NEC Corp., and Toyota.
Q: When layoffs start to mount and corporate earnings decline, is that a sign of impending recession? What is a recession?
A: The official definition is two consecutive quarters of decline in real gross domestic product (GDP).
The official arbiter of recession is the National Bureau of Economic Research (NBER), which assigns dates to the beginning and end of downturns. This nonprofit organization’s definition of a recession is slightly different: a decline in output and employment.
When output drops, businesses obviously don’t need to hire workers, and we then see a fairly immediate rise in the unemployment rate—which is why recessions are very closely associated with periods of declining employment and output.
Your question ties the issue of recession to declining corporate profits—certainly an important and key indicator (in addition to output and employment). However, I think an even more critical number to watch is leverage.
The Office of Comptroller of the Currency (OCC) regularly reports leverage trends. In a paper written in 2001, it noted that the level of troubled corporate debt at the largest U.S. banks was on the rise. In fact, the OCC considered $100 billion of commercial debt, out of $1.9 trillion, 'troubled.' That could signal major defaults that would send us spiraling into a recession.
Bear in mind that our major economic collapses have all stemmed from too much leverage. In 1929 it was margin leverage; in the 1980s it was too many bad real estate and commercial loans.
High levels of debt were around when the last official recession began in July 1990. Iraq invaded Kuwait and soaring oil prices resulted. Although inflation remained in check, the economy contracted 1 percent for the year and the S&P 500 dropped 3 percent, its first year-end loss since 1981.
Note: You can also take the pulse of troubled debt levels by tracking corporate bond ratings posted by Moody’s and S&P.
During a soft economy people have less money to spend, so that is not the best time to add stocks of automakers or luxury items to your portfolio. But consumer staples and health-care products—food, beverages, liquor, health-care items, toiletries, drugs, and cigarettes—do well in a recessionary environment.
Think about it. If you are laid off or concerned about getting that pink slip, you won’t stop buying bread, milk, deodorant, prescription medicines, aspirin, and soap. But you will likely eat out less, wait to move to a larger house, and delay buying a new car, a boat, or expensive pearls. Bottom line: Consider consumer staples and health-care stocks.
Q: How does a reverse stock split work?
A: A reverse split does two things: It reduces the number of outstanding shares that a company has, and it increases the par value of those shares.
Let’s say you own 10,000 shares and the company declares a one-for-ten reverse split—you now own 1,000. You own fewer shares, but your total investment hasn’t changed. Your stock is worth the same dollar amount it was just before the reverse split. On the other hand, each individual share is worth more than it was prior to the split.
Management often declares a reverse split when the stock’s per share price has fallen dramatically. Although the split reduces the number of outstanding shares, at the same time it makes each share more valuable. The rationale behind this move is that the higher price will make what has been a low-priced stock appear more attractive. This in turn may bring in more investors and thus boost the price even more. Although a reverse split is generally regarded as a negative, it may indeed push up a stock’s price, at least initially.
Another reason for reverse splits is to avoid being delisted. A stock can be delisted if its price does not meet the minimum standard set by Nasdaq or by the exchange on which it trades. A company’s management would obviously want to avoid that.
Q: I am a 19-year-old college student studying to be a doctor. I would like to save for the future but I don’t make very much money. What type of account or investment could I open with little money but still get good results?
A: Building up an account so you will have extra money for tuition, clothes, a car, vacation, and perhaps someday a house, is not as overwhelming as it may seem. In fact, a key point to keep in mind is: it’s not the amount you save that’s so important, but it’s the habit of regular saving that really counts. No dollar amount is ever too small to start with.
I recommend that you do two simple things: (1) Open either a money market fund account or a savings account at a bank that pays a decent rate—most banks do not. (2) Put your savings on automatic pilot. That means designating and transferring a certain dollar from your checking account into a savings account or, if you’re working, signing up for the automatic savings plan with your company.
Let’s start with a money market mutual fund. This type of savings account, offered by all the major mutual funds, including Strong, T. Rowe Price, Fidelity, Vanguard, etc., pays a higher interest rate than the vast majority of bank accounts and most also offer free checking. The minimum to open a money market account typically ranges from $1,000 to $2,500.
From time to time, the mutual fund companies waive those opening minimums provided you sign up for automatic savings.
After you’ve saved $5,000 to $10,000, consider bank CDs, U.S. Treasuries and other of funds where you can safely invest larger amounts and, at the same time, land an impressive return.
Q: How does one find out about a stock’s share volume rate—such as whether more shares are being sold or bought? Also, is there a way to tell the level of institutional buying and selling?
A: To answer the first part of your question, you can find a stock’s trading volume from the previous day in the financial pages of most newspapers. It is under the column labeled “VOL.”
Recently, newspapers in large cities have taken to putting the stock quotation in boldface if its priced changed 5 percent or more from the previous day—it’s a great way to spot those stocks in the news. The big papers also underline quotations for stocks with large changes in volume compared with the stock’s average trading volume.
A company’s Web site often provides some or all of the information you’re seeking. Look for it under headings such as 'Financials,' 'Company Snapshot,' or 'Investor News.'
Q: What is a stock split?
A: A stock split, which must be approved by a corporation’s board of directors, simply divides the number of outstanding shares into a larger number of shares. Splits can be 2 for 1, 3 for 1, 10 for 1, and so forth. Corporations usually vote to split the stock when the price has run up. By splitting the stock and thus lowering its price, corporations hope to stimulate trading.
When a stock is split, more shares are obviously available, but the total market value remains exactly the same. Think of it in terms of getting change for a dollar. Even though shareholders own more shares after a split, the total dollar value is the same. Sometimes the price of a stock moves up after the announcement of a forthcoming split. In addition, the resulting lower price per share after the split may also boost the price, but there is no guarantee that this will happen.
Q: I have money burning a hole in my pocket from my 2001 income tax refund. What do you suggest I do with it?
A: If you filed as a single person, you have $300 in your pocket; if you’re married and filed jointly, you have $600; if you filed as head of household, you have $500. Those are the maximum amounts.
If you earned less than $6,000, then your refund equals 5 percent of your income. Let’s say, for example, that your taxable income was $4,000. Then your check is $200. (Taxable income is income after credits, exemptions, and deductions.)
I don’t think everything about money should be heavy and serious. We are entitled to kick up our heels now and then. So my first suggestion is that you take part of your refund—but no more than a third—and do something fun with it. After all, this is found money. Why not dine at your favorite restaurant, catch a ball game, or see a play or movie?
Or you might want to mark the event by purchasing something you’ve been thinking about but know isn’t really necessary. Perhaps a pair of jogging shoes or outrageous sunglasses that glow in the dark. Maybe a special book, a new software package, or a Roy Orbison CD.
Then, once you’ve spent anywhere from $20 to $150 (depending on where you live, what you did, how many people you took along, or what item you bought), you’ll have several hundred dollars left. So ...
(1) PAY DOWN YOUR CREDIT CARD DEBT. If you haven’t been paying your credit card bills in full each month, I fear you could be paying as much as 20 to 24 percent in interest on the unpaid balance. Use your refund to get rid of as much debt as possible. Don’t even think twice about it.
If you owe money on several cards, start with the card that has the highest interest rate, which may or may not be the one with the largest balance.
(2) PUMP UP YOUR IRA. If you have earned income, you can contribute up to $2,000 this year to an individual retirement account (IRA). Based on the new tax rules, this amount goes up to $3,000 next year and gradually to $5,000 in 2008.
(3) MAX OUT YOUR 401(k). Speak with your benefits officer and have your paycheck deductions increased so that you will be contributing the remaining amount of your refund to your 401(k) or 403(b) retirement plan.
(4) INVEST IN A BANK CD. These certificates of deposit are a good way to save because if you cash them in early, you are hit with an interest rate penalty. That’s built-in discipline for people tempted to draw down their savings account. However, most banks insist that you have at least $1,000 to purchase a CD. This definitely creates a problem since the maximum you have burning that hole in your pocket is $600.
Q: If a person has two full-time jobs, can that person contribute to two 401(k) plans? Will the allowable tax-free contributions apply to both plans together or to each plan separately?
A: The good news is you can contribute to more than one 401(k) plan.
The sort of bad news is that the contribution limit applies to both plans together. This means you cannot contribute more than a total of $10,500 to your 401(k) plans this year.
That contribution limit will be going up in the years to come, however, thanks to the Tax Relief Act of 2001, which was signed into law by President Bush in June 2001.
Under the new law, the employee contribution limit for 401(k)s will rise to
$11,000 in 2002
$12,000 in 2003
$13,000 in 2004
$14,000 in 2005
$15,000 in 2006
After 2006, the limit will be adjusted for inflation each year.
Higher limits will apply to workers aged 50 or older. These people generally will be eligible to contribute $1,000 more than normally allowed in the year 2002. That figure will gradually rise to $5,000 in 2006.
If you have any other questions about this topic, check with your accountant, or feel free to write to me again. If you don’t have an accountant, ask your lawyer or smart friends for a referral. Or find one through the CPA Directory, which lists 450,000 CPAs in the United States. You can access them by name, geographical area, or area of expertise.
Q: What are zero-coupon bonds?
A: First, we need to define the term coupon. Years ago, bonds were sold with coupons attached, and every six months the bondholder would literally clip the coupon and present it to the bond issuer or a bank to receive the interest payment. This is rarely the case anymore because the bonds you own are registered in your name, and interest is automatically mailed to you. However, the use of coupon survives, indicating the interest payment on a bond. As the name implies, a zero-coupon bond has no coupon and pays no annual interest.
To compensate for this fact, zeros are sold at a deep discount from their face value, which is the amount the bond will be worth when it matures, or comes due (usually $1,000). When a zero-coupon bond matures, the investor receives one lump sum equal to the face value of the bond, which is equal to the initial investment plus accrued interest.
For example, a ten-year zero-coupon bond with a face value of $1,000 may cost just $400 or $500 to purchase. The bondholder will receive the face value, or $1,000, at the time of maturity—in this case, in ten years.
Bond issuers, of course, like this arrangement because they can use the money they’ve raised without making periodic interest payments to bond holders.
Zeros are a good choice when investing for long-term goals, such as paying for college tuition, because you can buy bonds timed to come due when you need cash to make payments.
Zeros come with some disadvantages, however. One is that, unless you buy tax-exempt municipal zeros, you have to pay taxes every year on the interest as if you had received it. So, if you buy taxable zeros, it’s a good idea to put them in a tax-advantaged account, such as an IRA. (The issuer will send you a Form 1099-OID [Original Issue Discount], which lists the imputed, or phantom, interest.)
Another negative: Zeros fluctuate sharply in value, depending upon interest rate movement. That’s why it’s best to keep these bonds until they mature. If you need to sell them before maturity, they may have gone down in value.
There are three main categories of zeros: those offered by the United States Treasury, by state and local municipalities, and by corporations. Corporate zero-coupon bonds carry the highest degree of risk but also the higher yields.
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Bond (finance); Stock (business); Investment
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