Choosing investment vehicles

Creating an investment portfolio

Investing in bonds

Investing in stocks

Market Capitalization

Mutual fund basics

Other investments

The best ways to save for college

Understanding mutual fund share classes

Investment basics

An Old Wall Street Saying

Handling market volatility

Investment planning--the basics

Monitor the Progress of Your Investments

Six keys to successful investing

Taxation of investments

The Rule of 72

Understanding investment terms and concepts

Understanding risk

What Savings or Investment Products Are Not FDIC Insured

Investment

goals

Asset allocation

Can I afford to send my child to college?

Common investment goals

Dollar cost averaging

Retirement planning--the basics

Tools

Investment planning basics

Annual Stock Option Grants

Asset allocation pie chart illustrator

Asset Allocator

College funding options analyzer

Common investment mistakes to avoid

Consumer price index inflation calculator

Future Contracts Calculator

Growth of annual deposits calculator

Investment Loan

Investment Returns

Simple rules for investing

Steps to financial planning success

Stock Option Calculator

What is your risk tolerance?

Taxes

Capital gains

Jobs and Growth Tax Relief Reconciliation Act of 2003: Highlights

and dividends tax relief

FAQs

Creating an investment portfolio

How aggressive should I be when I invest for retirement?

How do I construct an investment portfolio that's right for me?

How long should I hang on to an investment?

How much of my portfolio should I keep in stocks?

How should I structure my retirement portfolio?

Investing basics

How can I gauge my risk tolerance?

Is there any type of insurance that can protect against losses from investments?

Should I invest my extra cash or use it to pay off debt?

What is asset allocation and how does it work?

What is dollar cost averaging and how do I know if it's right for me?

What's the difference between growth investing and value investing?

Mutual funds

Is it better to invest in a tax-free or a taxable mutual fund?

Should I invest in mutual funds or individual securities?

What is a mutual fund prospectus and how do I read it?

What is the difference between an open-end and a closed-end mutual fund?

Savings bonds

Are government savings bonds risk free?

Are savings bonds a good way to save?

Do series EE bonds offer any special advantages if used for college savings?

Stocks

Should I invest in mutual

Should I work with a stockbroker to buy individual stocks?

funds or individual securities?

What are DRIPs?

What is a stock split?

Who do I call if I have a complaint about my stockbroker?

Taxes

How did the Jobs and Growth Tax Relief Reconciliation Act of 2003 change capital gains tax rates?

I have investment property. What does basis mean, and how do I determine the basis of my property?

Will I have to pay tax on my investment income?

 

The 360 Degrees of Financial Literacy Web site offers general information for managing personal finances and does not recommend specific financial actions.  For financial advice tailored to your situation, please contact an expert such as a CPA or a personal financial advisor.

UNDERSTANDING INVESTMENT TERMS AND CONCEPTS

Below are summaries of some basic principles you should understand when evaluating an investment opportunity or making an investment decision. Rest assured, this is not rocket science. In fact, you'll see that the most important principle on which to base your investment education is simply good common sense.You've decided to start investing. If you've had little or no experience, you're probably apprehensive about how to begin. Even after you've found a trusted financial advisor, it's wise to educate yourself, so you can evaluate his or her advice and ask good questions. The better you understand the advice you get, the more comfortable you will be with the course you've chosen.

Don't be intimidated by jargon

Don't worry if you can't understand the experts in the financial media right away. Much of what they say is jargon that is actually less complicated than it sounds. You'll learn it soon enough, and there is no reason to wait to invest until you know everything.

IRAs hold investments--they aren't investments themselves

As a preliminary matter, let's address a source of confusion that immediately throws many new investors off: If you have an individual retirement account (IRA), a 401(k), or other retirement plan at work, you should recognize the distinction between that account or plan itself and the actual investments you own within that account or plan. Your IRA or 401(k) is really just a container that holds investments and has special tax advantages. Folks often get confused when that distinction is not pointed out.

Understand stocks and bonds

Almost every portfolio contains one or both of these kinds of assets.

If you buy stock in a company, you are literally buying a share of it from an existing owner who wants to sell. You become an owner, or shareholder, of the company. As such, you take a stake in the company's future. If the company prospers, there's no limit to how much your share can increase in value. If the company fails, you can lose every dollar of your investment.

If you buy bonds, you're lending money to the company (or governmental body) that issued the bonds. You become a creditor, not an owner, of the bond issuer. The bond is your IOU. As a lender, your return is limited to the interest rate and terms under which the bond was issued. You can still lose the amount of the loan (your investment) if the company or governmental body fails, but the risk of loss to creditors (bondholders) is generally less than the risk for owners (shareholders). This is because, to stay in business, a company must maintain as good a credit rating as possible, so creditors will usually pay on time if there is any way at all to do so. In addition, the law favors bondholders over shareholders in the event of bankruptcy.

As a matter of jargon, stocks (and stock mutual funds) are referred to as equity investments, while bonds (and mutual funds containing bonds) are often called investments in debt.

Diversify--don't put all your eggs in one basket

This is the most important of all investment principles, as well as the most familiar and sensible.

Consider using several different classes of investments for your portfolio. Examples of investment classes include stocks, bonds, mutual funds, art, and precious metals. These classes are often further broken down according to more precise investment characteristics (e.g., stocks of small companies, stocks of large companies, bonds issued by cities, bonds issued by the U.S. Treasury).

Investment classes often rise and fall at different rates and times. Ideally, in a diversified portfolio of investments, if some are losing value during a particular period, others will be gaining value at the same time. The gainers help offset the losers, and the total risk of loss is minimized. The goal is to find the right balance of different assets for your portfolio. This process is called asset allocation.

Within each class you choose, consider diversifying further among several individual investment options within that class. For example, if you've decided to invest in the drug industry, it might be wise to make smaller investments in Company A, Company B, and Company C, rather than put all your chips on one of them.

Recognize the tradeoff between the risk and return of an investment

For present purposes, we define risk as the possibility of losing your money, or that your investments will produce lower returns than expected. Return, of course, is your reward for making the investment. Return can be measured by an increase in the value of your initial investment principal and/or by cash payments directly to you during the life of the investment. There is a direct relationship between investment risk and return.

When someone proposes an investment and suggests otherwise, we know, "it's too good to be true." Invariably, the lowest-risk investments will be among the lowest-returning at any given time (e.g., a federally guaranteed bank certificate of deposit). The highest-risk investments will offer the chance for the highest returns (e.g., stock in an Internet start-up company that goes from $12 per share to $150, then down to $3).

Between the extremes, every investor searches to find a level of risk--and corresponding expected return--that he or she feels comfortable with.

Understand the difference between investing for growth and investing for income

As an investor, you face an immediate choice: Do you want growth in the value of your original investment over time, or is your goal to produce predictable, spendable current income--or a little of both?

Consistent with this investor choice, investments are frequently classified or marketed as either growth or income oriented. U.S. Treasury notes, for example, provide regular interest payments, but if you spend that money, of course, your original investment cannot grow.

In contrast, investing in a new software company, for example, will typically produce no immediate income. New companies generally reinvest any income in the business to make it grow. If they are successful, the value of your stake in the company should likewise grow over time.

There is no right or wrong answer to the "growth or income" question. Your decision should depend on your individual circumstances and needs (e.g., your need, if any, for income today, or your need to accumulate a college fund, not to be tapped for 15 years).

Understand the power of compounding on your investment returns

To help make an educated "growth or income" decision, you should have a feel for the result of either approach. With an investment made primarily for the production of current income, you'll know in advance the size and timing of payments to expect.

To evaluate the "growth" approach, you'll need to appreciate the concept of compounding. Compounding is what happens when you "let your money ride." Unlike the income investor, who usually takes his or her money "off the table" as the checks arrive, the growth investor lets investment returns remain invested, thereby earning a "return on the returns."

A simple example of compounding occurs with a bank certificate of deposit that is allowed to roll over each time it matures. Interest earned in one period becomes part of the investment itself, earning interest in subsequent periods. In the early years of an investment, the benefit of compounding on overall return is not exciting. As the years go by, however, a "rolling snowball" effect seems to operate, and the compounding's long-term boost to investment return becomes dramatic.

An Old Wall Street Saying

An Old Wall Street Saying

If you choose an investment because you think it will make you a lot of money fast, you may be taking a big risk. An old Wall Street saying goes: Bulls make money, bears make money, pigs get slaughtered. Before you invest in anything, make sure you understand and can live with the risk.

HANDLING MARKET VOLATILITY

Conventional wisdom says that what goes up, must come down. But even if you view market volatility as a normal occurrence, it can be tough to handle when it's your money at stake.

Though there's no foolproof way to handle the ups and downs of the stock market, the following common sense tips can help.

Don't put your eggs all in one basket

Diversifying your investment portfolio is one of the key ways you can handle market volatility. Because asset classes typically perform differently under different market conditions, spreading your assets across a variety of different investments such as stocks, bonds, and cash equivalents (e.g., money market funds, CDs, and other short-term instruments), can help reduce your overall risk. Ideally, a decline in one type of asset will be balanced out by a gain in another.

One way to diversify your portfolio is through asset allocation. Asset allocation involves identifying the asset classes that are appropriate for you and allocating a certain percentage of your investment dollars to each class (e.g., 70 percent to stocks, 20 percent to bonds, 10 percent to cash equivalents). An easy way to decide on an appropriate mix of investments is to use a worksheet or an interactive tool that suggests a model or sample allocation based on your investment objectives, risk tolerance level, and investment time horizon.

Focus on the forest, not on the trees

As the market goes up and down, it's easy to become too focused on day-to-day returns. Instead, keep your eyes on your long-term investing goals and your overall portfolio. Although only you can decide how much investment risk you can handle, if you still have years to invest, don't overestimate the effect of short-term price fluctuations on your portfolio.

Look before you leap

When the market goes down and investment losses pile up, you may be tempted to pull out of the stock market altogether and look for less volatile investments. The small

returns that typically accompany low-risk investments may seem downright attractive when more risky investments are posting negative returns.

But before you leap into a different investment strategy, make sure you're doing it for the right reasons. How you choose to invest your money should be consistent with your goals and time horizon.

For instance, putting a larger percentage of your investment dollars into vehicles that offer safety of principal and liquidity (the opportunity to easily access your funds) may be the right strategy for you if your investment goals are short-term (e.g., you'll need the money soon to buy a house) or if you're growing close to reaching a long-term goal such as retirement. But if you still have years to invest, keep in mind that stocks have historically outperformed stable value investments over time, although past performance is no guarantee of future results. If you move most or all of your investment dollars into conservative investments, you've not only locked in any losses you might have, but you've also sacrificed the potential for higher returns.

Look for the silver lining

A down market, like every cloud, has a silver lining. The silver lining of a down market is the opportunity you have to buy shares of stock at lower prices.

One of the ways you can do this is by using dollar cost averaging. With dollar cost averaging, you don't try to "time the market" by buying shares at the moment when the price is lowest. In fact, you don't worry about price at all. Instead, you invest money at regular intervals over time. When the price is higher, your investment dollars buy fewer shares of stock, but when the price is lower, the same dollar amount will buy you more shares. Although dollar cost averaging can't guarantee you a profit or a loss, a regular fixed dollar investment may result in a lower average price per share over time, assuming you invest through all types of markets.

Don't count your chickens before they hatch

As the market recovers from a down cycle, elation quickly sets in. If the upswing lasts long enough, it's easy to believe that investing in the stock market is a sure thing. But, of course, it never is. As many investors have learned the hard way, becoming overly optimistic about investing during the good times can be as detrimental as worrying too much during the bad times. The right approach during all kinds of markets is to be realistic. Have a plan, stick with it, and strike a comfortable balance between risk and return.

Don't stick your head in the sand

While focusing too much on short-term gains or losses is unwise, so is ignoring your investments. You should check up on your portfolio at least once a year, more frequently if the market is particularly volatile or when there have been significant changes in your life. You may need to rebalance your portfolio to bring it back in line with your investment goals and risk tolerance. If you need help, a financial professional can help you decide which investment options are right for you.

INVESTMENT PLANNING--THE BASICS

Why do so many people never obtain the financial independence that they desire? Often it's because they just don't take that first step--getting started. Besides procrastination, other excuses that people make are that investing is too risky, too complicated, too time consuming, and only for the rich.

The fact is, there's nothing complicated about common investing techniques, and it usually doesn't take much time to understand the basics. Investing is for everyone, not just the rich. And the biggest risk you face is not educating yourself.

Saving versus investing

Both saving and investing have a place in your finances. But don't confuse the two. With savings, your principal typically remains constant and earns interest or dividends. Savings are kept in certificates of deposit (CDs), checking accounts, money market accounts, and passbook savings accounts. By comparison, investments can go up or down in value and may or may not pay interest or dividends. Examples of investments include stocks, bonds, mutual funds, collectibles, precious metals, and real estate.

Why invest?

You invest for the future, and the future is expensive. For example, college expenses are increasing at double the rate of inflation, and people are retiring earlier and living longer.

You have to take responsibility for your own finances--nobody else is going to. Government programs like Social Security will probably play a less significant role in your life than they did for previous generations. Corporations are switching from guaranteed pensions to plans that require you to make contributions and choose investments. The better you manage your dollars, the more likely it is that you'll have the money you want for your retirement.

Because everyone has different goals and expectations, everyone has different reasons for investing. However, it simply comes down to managing your money to provide a comfortable life and financial security for you and your family.

What is the best way to invest? Get in the habit of saving. You must set aside a portion of your income as often as

possible. Invest in financial markets so your money can grow at a meaningful rate. Ignore short-term price fluctuations, and focus on long-term potential. Ask questions and become educated before making any investment. Invest with your head, not with your stomach or heart. Avoid the urge to invest

based on how you feel about an investment.

Before you start

Organize your finances to help manage your money more efficiently. Remember, investing is just one component of your overall financial plan. Get a clear picture of where you are today.

What's your net worth? Compare your assets with your liabilities. Look at your cash flow. Get a grasp on the amount of income that you're receiving, and where that income is going each month. List your expenses. You can typically identify enough expenses to account for at least 95 percent of your income. If not, go back and look again. You could use those lost dollars for investing. Are you drowning in credit card debt? If so, pay it off as quickly as possible before you start investing. Every dollar that you save in interest charges is one more dollar that you can invest for your future.

Establish a solid financial base: Make sure you have an adequate emergency fund, sufficient insurance coverage, and a realistic budget. Also, take full advantage of benefits and retirement plans that your employer offers.

Understand the impact of time

Take advantage of the power of compounding. Compounding is the earning of interest on interest, or the reinvestment of income. For instance, if you invest $1,000 at 8 percent, you will earn $80. By reinvesting the earnings and assuming the same rate of return, next year you will earn $86.40 on your $1,080 investment. The following year, $1,166.40 will earn $93.31.

Use the Rule of 72 to judge an investment's potential. Divide the projected return into 72. The answer is the number of years that it will take for the investment to double in value. For example, an investment that earns 8 percent per year will double in 9 years.

Consider working with a financial planner

Whether you need a financial planner depends on your own comfort level. If you have the time and energy to educate yourself, you may not need any assistance. However, don't underestimate the value of the experience and knowledge that a professional financial advisor can offer. A financial planner can help you define your goals and objectives, make a net worth statement and a spending plan, decide the level of risk that's right for you, and work with you to create a comprehensive financial plan. For many, working with a professional advisor is the single most important investment that they make.

Review your progress

Financial management is an ongoing process. Keep good records and recalculate your net worth annually. This will help you for tax purposes and show you how your investments are doing over time. Once you take that first step of getting started, you will be better able to manage your money to help afford today's needs and pay for tomorrow's goals.

Monitor the Progress of Your Investments

Monitor the Progress of Your Investments

As you regularly review your portfolio, consider these basic questions regarding the performance of your investments:

Is the return meeting your expectations? Have your investment goals, time horizons, or liquidity needs changed? If so, are

your investments still suitable? Do you fully understand your account statements? Are the criteria you use to decide when to buy, hold, or sell still valid? How much gain (or loss) will you realize if you sell today? What will the tax

consequences be?

SIX KEYS TO SUCCESSFUL INVESTING

A successful investor maximizes gain and minimizes loss. Here are six basic principles that may help you invest successfully.

Long-term compounding: your nest egg may get bigger, and bigger, and bigger . . .

It's the "rolling snowball" effect. Put simply, compounding pays you earnings on your reinvested earnings. The longer you leave your money at work for you, the more exciting the numbers get. For example, imagine an investment of $10,000 at an annual rate of return of 8 percent. In 20 years, assuming no withdrawals, your $10,000 investment would grow to $46,610. In 25 years, it would grow to $68,485, a 47 percent gain over the 20-year figure. After 30 years, your account would total $100,627. (Of course, this is a hypothetical example that does not reflect the performance of any specific investment.)

This simple example also assumes that no taxes are paid along the way, so all money stays invested. That would be the case in a tax-deferred individual retirement account or qualified retirement plan, or even if you just bought and held shares of a stock that paid no dividends. The compounded earnings of deferred tax dollars are the main reason experts recommend fully funding all tax-advantaged retirement accounts and plans available to you.

While you should review your portfolio on a regular basis, the point is that money left alone in an investment offers the potential of a significant return over time. With time on your side, you don't have to go for investment "home runs" in order to be successful.

Endure short-term pain for long-term gain: ride out market volatility

It sounds simple, doesn't it? But what if you've invested $10,000 in the stock market and the price of the stock drops like a stone one day? On paper, you've lost a bundle, offsetting the value of compounding you're trying to achieve. It's tough to stand pat.

There's no denying it--the financial marketplace can be volatile. Still, it's important to remember two things. First, the longer you stay with a diversified portfolio of investments, the more likely you are to reduce your risk and improve your opportunities for gain.

Second, during any given period of market or economic turmoil, some asset categories and some individual investments historically have been less volatile than others. Bond price swings, for example, have generally been less volatile than stock prices. Although past performance cannot predict future results, you can minimize your risk somewhat by diversifying your holdings among different classes of assets, as well as different individual assets within each class.

Asset allocation: spreading the wealth

Asset allocation is the process by which you spread your investment dollars over several categories of assets, usually referred to as asset classes. These classes include stocks, bonds, cash (and equivalents), real estate, precious metals, collectibles, and insurance products.

For many average investors, the focus is almost entirely on stocks, bonds (or mutual funds of stocks and bonds), and cash. You'll therefore also see the term asset classes used to refer to subcategories of these investments, such as aggressive growth stocks, long-term growth stocks, international stocks, government bonds (U.S., state, and local), high-quality corporate bonds, low-quality corporate bonds, and tax-free municipal bonds.

There are two main reasons why asset allocation is important. First, the mix of asset classes you own is a large factor--some say the biggest by far--in determining your

overall investment portfolio performance. In other words, the basic decision to divide your money 80 percent in stocks and 20 percent in bonds is probably more important than your subsequent decisions over exactly which companies to invest in, for example.

Second, by dividing your investment dollars among asset classes that do not respond to the same market forces in the same way at the same time, you can minimize the effects of market volatility while maximizing your chances of return in the long term. Ideally, if your investments in one class are performing poorly, you will have assets in another class doing well. The gains in the latter will offset the losses in the former, minimizing the overall effect on your portfolio.

Consider liquidity in your investment choices

Liquidity refers to how quickly you can convert an investment into cash without loss of principal. Generally speaking, the sooner you'll need your money, the wiser it is to keep it in investments with comparatively less volatile price movements. You want to avoid a situation, for example, where you need to write a tuition check next Tuesday, but the money is tied up in a long-term mutual fund whose price is currently experiencing a loss.

Therefore, your liquidity needs should affect your investment choices. If you'll need the money within the next one to three years, you may want to invest in short-term bonds, certificates of deposit, a money market account, or a savings account. Your rate of return will likely be lower than that possible with more volatile investments such as stocks, but you'll breathe easier knowing that the principal you invested is relatively safe and quickly available, without concern over market conditions on a given day.

Dollar cost averaging: doing it consistently and often

Dollar cost averaging is a method of accumulating shares of stock or a mutual fund by purchasing a fixed dollar amount of these securities at regularly scheduled intervals over an extended time. When the price is high, your fixed-dollar investment buys less, but when the prices are low, the same dollar investment will buy more shares. A regular, fixed-dollar investment should result in a lower average price per share than you would get buying a fixed number of shares at each investment interval.

Remember that, just as with any investment strategy, dollar cost averaging can't guarantee you a profit or protect you against a loss if the market is declining. To maximize the potential effects of dollar cost averaging, you should also assess your ability to keep investing even when the market is down.

An alternative to dollar cost averaging would be trying to "time the market," in an effort to predict how the price of the shares will fluctuate in the months ahead so you can make your full investment at the absolute lowest point. However, market timing is generally

unprofitable guesswork. The discipline of regular saving is a much more beneficial strategy, and it takes no mental effort or study.

Review your portfolio and game plan: buy and hold, don't buy and forget

Unless you plan to rely on luck, your portfolio's long-term success will depend on periodically reviewing it. Maybe your uncle's hot stock tip has frozen over. Maybe economic conditions have changed the prospects for a particular--or a whole class of--investment.

Even if nothing bad at all happens, your investments will appreciate at differing rates, so after a while, your asset allocation mix will change. For example, if you initially decided on an 80 percent to 20 percent mix of stocks to bonds, you might find that the total value of your portfolio has become divided 88 percent to 12 percent. When that's the case, you'll need to rebalance your portfolio.

Rebalancing involves restoring your original asset allocation decisions by shifting your funds among investment classes to restore the ratios you decided on in first designing your portfolio. Many investment advisors recommend using shifts of 5 percent or more as a trigger for rebalancing. Others recommend doing it every year.

TAXATION OF INVESTMENTS

It's nice to own stocks, bonds, and other investments. Nice, that is, until it's time to fill out your federal income tax return. At that point, you may be left scratching your head. Just how do you report your investments and how are they taxed?

Is it ordinary income or a capital gain?

To determine how an investment vehicle is taxed in a given year, first ask yourself what went on with the investment that year. Did it generate income, such as interest? If so, the income is probably considered ordinary. Did you sell the investment? If so, a capital gain or loss is probably involved. (Certain investments can generate both ordinary income and capital gain income, but we won't get into that here.)

If you receive dividend income, it may be taxed either as ordinary income or capital gain income. Under the Jobs and Growth Tax Relief Reconciliation Act of 2003, dividends paid to an individual shareholder from a domestic corporation or qualified foreign corporation are generally taxed at the same rates that apply to long-term capital gains. These rates are 15 percent for an individual in a marginal tax rate bracket that is greater than 15 percent or 5 percent (reduced to zero in 2008) for an individual in the 10 or 15 percent marginal tax rate bracket. But special rules and exclusions apply, and some

dividends (such as those from money market mutual funds) continue to be treated as ordinary income.

The distinction between ordinary income and capital gain income is important because different tax rates may apply and different reporting procedures may be involved. Here are some of the things you need to know.

Categorizing your ordinary income

Investments often produce ordinary income. Examples of ordinary income include interest and rent. Many investments--including savings accounts, certificates of deposit, money market accounts, annuities, bonds, and some preferred stock--can generate ordinary income. Ordinary income is taxed at ordinary (as opposed to capital gains) tax rates.

But not all ordinary income is taxable--and even if it is taxable, it may not be taxed immediately. If you receive ordinary income, you must categorize it as taxable, tax exempt, or tax deferred.

Taxable income: This is income that's not tax exempt or tax deferred. If you receive ordinary taxable income from your investments, you'll report it on your federal income tax return. In some cases, you may have to detail your investments and income on Schedule B.

Tax-exempt income: This is income that's free from federal and/or state income tax, depending on the type of investment vehicle and the state of issue. Municipal bonds and U.S. securities are typical examples of investments that generate tax-exempt income.

Tax-deferred income: This is income whose taxation is postponed until the future. For example, with a 401(k) retirement plan, earnings are reinvested and taxed only when you take money out of the plan. The income earned in the 401(k) plan is tax deferred.

A quick word about ordinary losses: It's possible for an investment to generate an ordinary loss, rather than ordinary income. In general, ordinary losses reduce ordinary income.

Understanding what basis means

Let's move on to what happens when you sell an investment vehicle. Before getting into capital gains and losses, though, you need to understand an important term--basis. Generally speaking, basis refers to the amount of your investment in an asset. To calculate the capital gain or loss when you sell or exchange an asset, you must know how to determine both your initial basis and adjusted basis in the asset.

First, initial basis. Usually, your initial basis equals your cost--what you paid for the asset. For example, if you purchased one share of stock for $10,000, your initial basis in the stock is $10,000. However, your initial basis can differ from the cost if you did not purchase an asset but rather received it as a gift or inheritance, or in a tax-free exchange.

Next, adjusted basis. Your initial basis in an asset can increase or decrease over time in certain circumstances. For example, if you buy a house for $100,000, your initial basis in the house will be $100,000. If you later improve your home by installing a $5,000 deck, your adjusted basis in the house may be $105,000. You should be aware of which items increase the basis of your asset, and which items decrease the basis of your asset. See IRS Publication 551 for details.

Calculating your capital gain or loss

If you sell stocks, bonds, or other capital assets, you'll end up with a capital gain or loss. Special capital gains tax rates may apply. These rates may be lower than ordinary income tax rates.

Basically, capital gain (or loss) equals the amount that you realize on the sale of your asset (i.e., the amount of cash and/or the value of any property you receive) less your adjusted basis in the asset. If you sell an asset for more than your adjusted basis in the asset, you'll have a capital gain. For example, assume you had an adjusted basis in stock of $10,000. If you sell the stock for $15,000, your capital gain will be $5,000. If you sell an asset for less than your adjusted basis in the asset, you'll have a capital loss. For example, assume you had an adjusted basis in stock of $10,000. If you sell the stock for $8,000, your capital loss will be $2,000.

Schedule D of your income tax return is where you'll calculate your short-term and long-term capital gains and losses, and figure the tax due, if any. You'll need to know not only your adjusted basis and the amount realized from each sale, but also your holding period, your marginal income tax bracket, and the type of asset(s) involved. See IRS Publication 544 for details.

Holding period: Generally, the holding period refers to how long you owned an asset. A capital gain is classified as short term if the asset was held for a year or less, and long term if the asset was held for more than one year. The tax rates applied to long-term capital gain income are generally lower than those applied to short-term capital gain income. Short-term capital gains are taxed at the same rate as your ordinary income.

Marginal income tax bracket: Marginal income tax brackets are expressed by their marginal tax rate (e.g., 15 percent, 25 percent). Your marginal tax bracket depends on your filing status and the level of your taxable income. When you sell an asset, the capital gains tax rate that applies to the gain will depend on your marginal income tax bracket. Generally, a 5 percent long-term capital gains tax

rate applies to individuals in the 10 or 15 percent tax bracket (this rate will be reduced to zero in 2008), while the long-term capital gains of individuals in the other tax brackets are subject to a 15 percent rate.

Type of asset: The type of asset that you sell will dictate the capital gain rate that applies, and possibly the steps that you should take to calculate the capital gain (or loss). For instance, the sale of an antique is taxed at the maximum tax rate of 28 percent even if you held the antique for more than 12 months.

Using capital losses to reduce your tax liability

You can use capital losses from one investment to reduce the capital gains from other investments. You can also use a capital loss against up to $3,000 of ordinary income this year ($1,500 for married persons filing separately). Losses not used this year can offset future capital gains. Schedule D of your federal income tax return can lead you through this process.

Getting help when things get too complicated

The sale of some assets are more difficult to calculate and report than others, so you may need to consult an IRS publication or other tax references to properly calculate your capital gain or loss. Also, remember that you can always seek the assistance of an accountant or other tax professional.

The Rule of 72

The Rule of 72

To determine the number of years it will take an investment to double in value, divide 72 by the interest rate. For example, $1,000 invested at 6 percent will become $2,000 in 12 years (72 divided by 6 equals 12).

UNDERSTANDING INVESTMENT TERMS AND CONCEPTS

Below are summaries of some basic principles you should understand when evaluating an investment opportunity or making an investment decision. Rest assured, this is not rocket science. In fact, you'll see that the most important principle on which to base your investment education is simply good common sense.You've decided to start investing. If you've had little or no experience, you're probably apprehensive about how to begin. Even after you've found a trusted financial advisor, it's wise to educate yourself, so you can evaluate his or her advice and ask good questions. The better you understand the advice you get, the more comfortable you will be with the course you've chosen.

Don't be intimidated by jargon

Don't worry if you can't understand the experts in the financial media right away. Much of what they say is jargon that is actually less complicated than it sounds. You'll learn it soon enough, and there is no reason to wait to invest until you know everything.

IRAs hold investments--they aren't investments themselves

As a preliminary matter, let's address a source of confusion that immediately throws many new investors off: If you have an individual retirement account (IRA), a 401(k), or other retirement plan at work, you should recognize the distinction between that account or plan itself and the actual investments you own within that account or plan. Your IRA or 401(k) is really just a container that holds investments and has special tax advantages. Folks often get confused when that distinction is not pointed out.

Understand stocks and bonds

Almost every portfolio contains one or both of these kinds of assets.

If you buy stock in a company, you are literally buying a share of it from an existing owner who wants to sell. You become an owner, or shareholder, of the company. As such, you take a stake in the company's future. If the company prospers, there's no limit to how much your share can increase in value. If the company fails, you can lose every dollar of your investment.

If you buy bonds, you're lending money to the company (or governmental body) that issued the bonds. You become a creditor, not an owner, of the bond issuer. The bond is your IOU. As a lender, your return is limited to the interest rate and terms under which the bond was issued. You can still lose the amount of the loan (your investment) if the company or governmental body fails, but the risk of loss to creditors (bondholders) is generally less than the risk for owners (shareholders). This is because, to stay in business, a company must maintain as good a credit rating as possible, so creditors will usually pay on time if there is any way at all to do so. In addition, the law favors bondholders over shareholders in the event of bankruptcy.

As a matter of jargon, stocks (and stock mutual funds) are referred to as equity investments, while bonds (and mutual funds containing bonds) are often called investments in debt.

Diversify--don't put all your eggs in one basket

This is the most important of all investment principles, as well as the most familiar and sensible.

Consider using several different classes of investments for your portfolio. Examples of investment classes include stocks, bonds, mutual funds, art, and precious metals. These classes are often further broken down according to more precise investment characteristics (e.g., stocks of small companies, stocks of large companies, bonds issued by cities, bonds issued by the U.S. Treasury).

Investment classes often rise and fall at different rates and times. Ideally, in a diversified portfolio of investments, if some are losing value during a particular period, others will be gaining value at the same time. The gainers help offset the losers, and the total risk of loss is minimized. The goal is to find the right balance of different assets for your portfolio. This process is called asset allocation.

Within each class you choose, consider diversifying further among several individual investment options within that class. For example, if you've decided to invest in the drug industry, it might be wise to make smaller investments in Company A, Company B, and Company C, rather than put all your chips on one of them.

Recognize the tradeoff between the risk and return of an investment

For present purposes, we define risk as the possibility of losing your money, or that your investments will produce lower returns than expected. Return, of course, is your reward for making the investment. Return can be measured by an increase in the value of your initial investment principal and/or by cash payments directly to you during the life of the investment. There is a direct relationship between investment risk and return.

When someone proposes an investment and suggests otherwise, we know, "it's too good to be true." Invariably, the lowest-risk investments will be among the lowest-returning at any given time (e.g., a federally guaranteed bank certificate of deposit). The highest-risk investments will offer the chance for the highest returns (e.g., stock in an Internet start-up company that goes from $12 per share to $150, then down to $3).

Between the extremes, every investor searches to find a level of risk--and corresponding expected return--that he or she feels comfortable with.

Understand the difference between investing for growth and investing for income

As an investor, you face an immediate choice: Do you want growth in the value of your original investment over time, or is your goal to produce predictable, spendable current income--or a little of both?

Consistent with this investor choice, investments are frequently classified or marketed as either growth or income oriented. U.S. Treasury notes, for example, provide regular interest payments, but if you spend that money, of course, your original investment cannot grow.

In contrast, investing in a new software company, for example, will typically produce no immediate income. New companies generally reinvest any income in the business to make it grow. If they are successful, the value of your stake in the company should likewise grow over time.

There is no right or wrong answer to the "growth or income" question. Your decision should depend on your individual circumstances and needs (e.g., your need, if any, for income today, or your need to accumulate a college fund, not to be tapped for 15 years).

Understand the power of compounding on your investment returns

To help make an educated "growth or income" decision, you should have a feel for the result of either approach. With an investment made primarily for the production of current income, you'll know in advance the size and timing of payments to expect.

To evaluate the "growth" approach, you'll need to appreciate the concept of compounding. Compounding is what happens when you "let your money ride." Unlike the income investor, who usually takes his or her money "off the table" as the checks arrive, the growth investor lets investment returns remain invested, thereby earning a "return on the returns."

A simple example of compounding occurs with a bank certificate of deposit that is allowed to roll over each time it matures. Interest earned in one period becomes part of the investment itself, earning interest in subsequent periods. In the early years of an investment, the benefit of compounding on overall return is not exciting. As the years go by, however, a "rolling snowball" effect seems to operate, and the compounding's long-term boost to investment return becomes dramatic.

UNDERSTANDING RISK

Few terms in personal finance are as important, or used as frequently, as "risk." Nevertheless, few terms are as imprecisely defined. Almost universally, when financial advisors or the media talk about investment risk, their focus is on the historical price volatility of the asset or investment under discussion.

Advisors label as aggressive or risky an investment that was prone to wild price gyrations in the past. The presumed uncertainty and unpredictability of this investment's future performance is perceived as risk. Assets characterized by prices that historically have moved within a narrower range of peaks and valleys are considered more conservative.

Unfortunately, this explanation is seldom offered, so it is often not clear that the volatility yardstick is being used to measure risk.

Before exploring risk in more formal terms, a few observations are worthwhile. On a practical level, we can say that risk is the chance that your investment will provide lower returns than expected or even a loss of your entire investment. More to the point, you are concerned about the chance of not meeting your investment goals. After all, you are investing now so you can do something later (e.g., pay for college, retire comfortably). Since every investment carries some degree of risk, it makes sense to understand the kinds of risk as well as the extent of risk that you choose to take, and to learn to manage it.

What you probably already know about risk

Even though you might never have thought about the subject, you are already familiar with many kinds of risk from life experiences. For example, you know intuitively that a scandal or lawsuit that involves a particular company will likely cause a drop in the price of that company's stock, at least temporarily. You assume that if one car company hits a home run with a new model, that would be bad news for all competing automakers. In contrast, you'd expect an overall economic slowdown and stock market decline to hurt companies and their stock prices across the board, not just in one industry.

You must be mindful of these and other kinds of risks going forward. Volatility is a good place to begin, however, as we examine the elements of risk in more detail.

Volatility--why is it risky?

Suppose that you had invested $10,000 in each of two mutual funds 20 years ago, and that both funds produced average annual returns of 10 percent. Imagine further that one of the funds, Steady Freddy, returned exactly 10 percent every single year, unlike any real investment. The annual return of the second fund, Jekyll & Hyde, alternated--5 percent one year, 15 percent the next, 5 percent again in the third year, and so on. What would these two investments be worth at the end of the 20 years?

It seems obvious that if the average annual returns of two investments are identical, so will be their final values. But this is a case where intuition is wrong. If you plot the 20-year investment returns on a graph, you'll see that Steady Freddy's final value is over $2,000 more than what you'd get from the variable returns of Jekyll & Hyde. The shortfall gets much worse if you widen the annual variations (e.g., try plus-or-minus 15 percent, instead of plus-or-minus 5 percent). This example illustrates one of the effects of investment price volatility: Short-term fluctuations in returns are a drag on long-term growth.

Although past performance is no guarantee of future results, historically the negative effect of short-term price fluctuations has been reduced by holding investments over longer periods. But counting on a longer holding period means that some additional planning is called for. You should not invest funds that will soon be needed into a volatile investment. Otherwise, you might be forced to sell the investment to raise cash at a time when the investment is at a loss.

Other types of risk

Here are a few of the many different types of risk:

Market risk: This refers to the possibility that an investment will lose value because of a general decline in financial markets, due to one or more economic, political, or other factors.

Inflation risk: Sometimes known as purchasing power risk, this refers to the possibility that prices will rise in the economy as a whole, so your ability to purchase goods and services would decline. For instance, your investment might yield a 6 percent return, but if the inflation rate rises to double digits, the invested dollars that you got back would buy less than the same dollars today. Inflation risk is often overlooked by fixed income investors who shun the stock market completely, fearing the risks found there.

Interest rate risk: This relates to increases or decreases in prevailing interest rates and the resulting price fluctuation of an investment, particularly bonds. There is an inverse relationship between bond prices and interest rates. As interest rates rise, the price of bonds falls, and vice versa. If you need to sell your bond before maturity, you run the risk of loss of principal if interest rates are higher than when you purchased the bond.

Reinvestment rate risk: This refers to the possibility that you will have to reinvest funds at a lower rate of return than the original investment. Your five-year, 3.75 percent certificate of deposit might mature at a time when your only choice is to buy a new certificate of deposit at just 3 percent.

Default risk (credit risk): This refers to the risk that a bond issuer will not be able to pay its bondholders.

Liquidity risk: This refers to how easily your investments can be converted to cash. Occasionally (and more precisely), the foregoing definition is modified to mean how easily your investments can be converted to cash without significant loss of principal.

Political risk (for those making international investments): This refers to the possibility that changes in foreign governments or politics will adversely affect the financial markets there or the companies you invested in.

Exchange risk (for those making international investments): This refers to the possibility that the fluctuating rates of exchange between U.S. and foreign currencies will negatively affect the value of your foreign investment, as measured in U.S. dollars.

The relationship between risk and reward

In general, the more risk you're willing to take on (whatever type and however defined), the higher your potential returns, as well as potential losses. This proposition is probably familiar and makes sense to most of us. It is simply a fact of life--no sensible person would make a higher-risk, rather than lower-risk, investment without the prospect of a higher return. That is the tradeoff. Your goal is to maximize returns without taking on more risk than you can bear.

Understanding your own tolerance for risk

The concept of risk tolerance is twofold. It refers to both your personal desire to assume risk and your financial ability to endure risk. It also assumes that risk is relative to your own personality and feelings about taking chances. If you find that you can't sleep at night because you're worrying about your investments, you've assumed too much risk. Your financial ability to endure risk has more to do with your age, stage in life, how soon you'll need the money, and your financial goals. If you're investing for retirement and you're 35 years old, you can endure more risk than someone who is 10 years into retirement, because you have a longer time frame before you need the money. With 30 years to build your retirement fund, you have the ability to withstand short-term fluctuations in hopes of a greater long-term return.

Reducing risk through diversification

Don't put all your eggs in one basket. You can help offset the risk in any one investment by spreading your money among several asset classes. Diversification strategies take advantage of the fact that forces in the markets do not normally influence all types or classes of investment assets at the same time or in the same way. Swings in overall portfolio return can be smoothed out by diversifying your investments among assets that tend not to experience price fluctuations that mirror each other. In a slowing economy, for example, stock prices might be going down or sideways, while falling interest rates cause the price of bonds to rise.

In addition to diversifying among asset classes, you should consider diversification within an asset class. There are different types of investments within an asset class. For example, when investing in stocks, you can choose to invest in large companies that tend to be less risky than small companies. When investing in bonds, you can choose between Treasury securities and the more risky corporate securities. Or, you could decide to allocate a portion of your investment funds among all four types of investments. Diversifying within an asset class helps reduce the risk to your portfolio due to the impact of any one particular type of stock, bond, or mutual fund.

Evaluating risk--where to find information about investments

You should become fully informed about a product before you invest. There are numerous sources of information about investment products. You can find information in third-party business and financial publications and websites, as well as annual and other periodic financial reports. Obtain a prospectus if the investment is a mutual fund or an initial public offering, or an offering circular if the investment is a limited partnership or hedge fund.

Third-party business and financial publications can provide credit ratings, news stories, and financial information about a company. For mutual funds, third-party sources provide information such as ratings, financial analysis, and comparative performance relative to peers.

The prospectus for a mutual fund provides a vast amount of information, including the fund's investment objectives, the types of securities it invests in and risks that go along with those securities, past performance, expense information, and financial reports. If you are considering investing in an initial public offering (IPO), it is extremely important that you read the prospectus. The prospectus contains information about the company's products and/or services, operating history, future prospects, and management. The offering circular of a limited partnership or hedge fund should contain information similar to that of a prospectus for an IPO, as well as information regarding the general partner, special risks of investing in the product, and liquidity.

You can also check with the Securities and Exchange Commission (SEC). There, you can obtain reports disclosing significant events (e.g., the CEO plans to sell a large amount of shares; an investor plans to purchase a large amount of shares for a takeover) and financial reports. One of the easiest ways to get information is to go to the SEC's website.

This is some of the information that you can gather to help evaluate the risk of a particular investment.

What Savings or Investment Products Are Not FDIC Insured?

What Savings or Investment Products Are Not FDIC Insured?

Non-deposit investment products such as annuities, mutual funds, stocks, bonds, and U.S. Treasury securities are not insured by the FDIC. In contrast, deposit investments (e.g., savings accounts) are FDIC insured up to $100,000.

CREATING AN INVESTMENT PORTFOLIO

You've identified your goals and done some basic research. You understand the difference between a stock and a bond. But how do you actually go about creating an investment portfolio? What specific investments are right for you? What resources are out there to help you with investment decisions? Do you need a financial planner to help you get started?

A good investment portfolio will spread your risk

It is an almost universally accepted concept that any portfolio should include a mix of investments. These investments could include a mix of stocks, bonds, mutual funds, and other investment vehicles. A portfolio should also be balanced. That is, the portfolio should contain investments with varying levels of risk to help minimize exposure, should one of the portfolio holdings decline significantly.

Many investors make the mistake of putting all their eggs in one basket. For example, if you invest in one stock, and that stock goes through the roof, a fortune can be made. On the other hand, that stock can lose all its value, resulting in a total loss of your investment. Spreading your investment over several asset classes should help reduce your risk of losing your entire investment.

Asset allocation--which baskets do you put your eggs in?

Asset allocation is one of the first steps in creating a diversified investment portfolio. Asset allocation is the concept of deciding how your investment dollars should be allocated among broad investment classes, such as stocks, bonds, and cash equivalents. That is, rather than focusing on individual investments (such as which company's stock to buy), asset allocation approaches diversification from a more general viewpoint. For example, what percent of your portfolio should be in stocks? The underlying principle is that different classes of investments have shown different rates of return and levels of price volatility over time. Also, since different asset classes respond differently to the same news, your stocks may go down while your bonds go up, or vice versa. Diversifying your investments over different asset classes will help you minimize volatility while maximizing potential return.

So, how do you choose the mix that's right for you? Countless resources are available to assist you, including interactive tools and sample allocation models. Most of these take a number of variables--some objective (e.g., your age, the financial resources available to you, your time frames), some subjective (e.g., your tolerance for risk, your outlook on the economy)--and suggest a possible allocation mix. Tailoring this suggested allocation mix to your needs is up to you. Rather than do it yourself, you can work with a financial advisor.

More on diversification

Diversification isn't limited to asset allocation, either. It is also important to own different investments with different levels of volatility, even within an investment class. For example, if you want to invest a large percentage of your investment dollars in stocks, that may be all right--stocks may be inherently more volatile than bonds or money markets, but you may have the ability to balance a stock portfolio with both higher-volatility and lower-volatility stocks and to reduce exposure that way.

Diversification also naturally results from investing in mutual funds instead of in individual securities. Most mutual funds invest in dozens to hundreds of securities, including stocks, bonds, or other investment vehicles. Purchasing shares in a mutual fund reduces your exposure to any one security. In addition to instant diversification, you get the benefit of a professional money manager making investment decisions on your behalf.

Choose investments that match your tolerance for risk

Your goal is to get the highest return on your investment that you can, within your comfort level. Your tolerance for risk likely depends on several factors, including your objectives and goals, timelines for using this money, life stage, personality, knowledge, and investment experience. You'll want to choose a mix of investments that has the potential to provide the return you want at the level of risk you feel comfortable with.

For that reason, an investment professional will normally ask you questions so that he or she can gauge your risk tolerance, then tailor a portfolio to your risk profile.

Investment professionals and advisors

A wealth of investment information is available if you want to do your own research before making investment decisions. Many brokerage houses make their research available for free to customers through the Internet, for example.

However, many people aren't comfortable sifting through balance sheets, profit-and-loss statements, and performance reports. Or, they just don't know enough to make use of the information available to them. Others just don't have the time or energy.

For these people, an investment advisor or professional can be invaluable. There are three general groups that investment advisors and professionals fall into: stockbrokers, professional money managers, and financial planners.

Stockbrokers

Stockbrokers work for brokerage houses. Their level of knowledge and skill is highly variable, and they generally work on commission. If you're working with a stockbroker,

consider to the extent possible whether the broker seems to have your best interests at heart and listens well to your goals and objectives. Also, verify that the broker has the requisite skill and knowledge to assist you in your investment decisions. Ask for references, and check with the Securities and Exchange Commission for any customer complaints or disciplinary actions that may have been brought against the broker. Ask friends, family, and coworkers if they can recommend brokers whom they have used and worked well with.

Professional money managers

Professional money managers were once available only for extremely high net-worth individuals. But that has changed a bit now that competition for investment dollars has grown so much, due in part to the proliferation of discount brokers on the Internet. Now, many professional money managers have considerably lowered their initial investment requirements in an effort to attract more clients.

A professional money manager designs an investment portfolio tailored to the client's investment objectives. Fees are usually based on a sliding scale as a percent of assets under management--the more in the account, the less of a percentage you are charged. Management fees and expenses can vary widely among managers, and all fees and charges should be fully disclosed.

As with any professional, it is advisable to do some investigative work before deciding which manager will best suit your needs.

Financial planners

A financial planner is a professional advisor who can help you set financial goals and who can develop and help implement an appropriate financial plan that manages all aspects of your financial picture, including investing, retirement planning, estate planning, and protection planning. Unlike other financial advisors, a financial planner looks at your finances as an interrelated whole and helps you plan accordingly. Because anyone can call himself or herself a financial planner without being educated or licensed in the area, you should choose a financial planner carefully. Make sure you understand the kind of services the planner will provide you and what his or her qualifications are. Look for a financial planner with one or more of the following credentials:

Certified Financial Planner (CFP) Chartered Financial Consultant (ChFC) and Chartered Life Underwriter (CLU) Accredited Personal Financial Specialist (PFS) Registered Financial Planner (RFP)

Financial planners can be either fee based or commission based, so make sure you understand how a planner is compensated. As with any investment advisor, it's your

responsibility to ensure that the person you're considering is competent to handle your hard-earned money.

INVESTING IN BONDS

Bonds may not be as glamorous as stocks or commodities, but they are a significant component of most investment portfolios. Bonds are traded in huge volumes every day, but their full usefulness is often underappreciated and underestimated.

Why invest in bonds?

Bonds can help diversify your investment portfolio. Bonds offer fixed interest payments at regular intervals and can act as a hedge against the relative volatility of stocks, real estate, or precious metals. Because they pay a regular, fixed amount of interest, bonds can also provide you with a steady stream of income.

How bonds work

When you buy a bond, you are essentially loaning money to a bond issuer in need of cash to finance a venture or fund a program, such as a corporation or government agency. In return for your investment, you receive interest payments at regular intervals, based on a fixed annual rate (coupon rate). You are also paid the bond's full face amount at its stated maturity date.

You can purchase many bonds in denominations as low as $1,000. Some are backed by tangible assets, such as mortgage contracts, buildings, or equipment. In many other cases, you simply bank on the issuer's ability to pay. You can buy or sell bonds in the open market in the same manner as stocks and other securities. Therefore, bonds fluctuate in price, selling at a premium (above) or discount (below) to its face value (par value). Generally, the longer a bond's duration to maturity, the more volatile its price swings. These factors expose bonds to certain inherent risks.

Bond risk factors

Although many bonds are conservative, lower-risk investments, many others are not, and all carry some risk. Because bonds are traded in the securities markets, there is always the chance that your bonds can lose favor and drop in price due to market risk. Much of this volatility in prices is tied to interest-rate fluctuations. For example, if you pay $1,000 for a 10 percent bond, that same $1,000 might buy you an 11 percent bond the following month, if interest rates rise. Consequently, your old 10 percent bond may be worth only about $900 to current investors.

Since bonds typically pay a fixed rate of interest, they are open to inflation risk. As consumer prices generally rise, the purchasing power of all fixed investments is reduced. Also, there is a chance that the issuer will be unable to make its interest payments or to repay its bonds' face value at maturity. This is known as credit or financial risk. To help minimize this risk, compare the relative strength of companies or bonds through a ratings service such as Moody's, Standard & Poor's, A. M. Best, or Fitch.

Corporate bonds

Bonds issued by private corporations vary in risk from typically super-steady utility bonds to highly volatile, high-interest junk bonds. Also, many corporate bonds are callable, meaning that they can be called in by the issuing company and redeemed on a fixed date. The company pays back your principal along with accrued interest, plus an additional amount for calling the bond before maturity.

Some corporate bonds are convertible and can be exchanged for shares of the company's stock on a fixed date. You can also purchase zero-coupon bonds that are issued at a discount, below face value. No interest is paid, but at maturity you receive the face value of the bond. For example, you pay $600 for a 5-year, $1,000 zero-coupon bond. At the end of 5 years, you receive $1,000. Corporate bonds have maturity dates ranging from one day to 40 years or more and generally make fixed interest payments every six months.

U.S. government securities

The securities backed by the full faith and credit of the U.S. government carry minimal risk. United States Treasury bills (T-bills) are issued for periods from 4 to 26 weeks. They are sold at a discount and are redeemed for their full face value at maturity. Other Treasury securities include Treasury notes, which mature between 1 and 10 years, and the benchmark U.S. Treasury bond, issued for periods of up to 10 years. Although the interest earned on these securities is subject to federal taxation, it is not subject to state or local taxes.

Various federal agencies also issue bonds. As with any investment, these bonds carry some risk. However, because the U.S. government guarantees timely payment of principal and interest on them, they are considered very safe. Some of these bonds use mortgages as collateral. Most mortgage-backed securities pay monthly interest to bondholders.

Municipal bonds

Municipal bonds (munis) are issued by states, counties, or municipalities, and are free from federal taxation. Some may be completely tax free if you are a resident of the state,

county, or municipality of issuance. Though municipal bonds generally offer lower interest payments compared with taxable bonds, their overall return may be higher because of their tax-reduced (or tax-free) status.

Munis come in two types: general obligation (GO) bonds and revenue bonds. GO bonds are backed by the taxing authority of the issuing state or local government. For this reason, they are considered less risky but have a lower coupon rate. Revenue bonds are supported by money raised from the bridge, toll road, or other facility that the bonds were issued to fund. They pay a higher interest rate and are considered riskier. Therefore, research the project being funded to the extent possible before you invest, to make sure that it will generate sufficient income to make payments.

How to begin investing in bonds

Thousands of books, newsletters, and websites can provide you with investment information. The major bond-rating services offer concise letter grades regarding the relative strength of a corporation or bond. So, the tools to empower you to evaluate and choose bonds are at your disposal.

However, if you don't want to go it alone, a brokerage firm or financial advisor can evaluate and recommend choices for you. Keep in mind that brokers or advisors may charge a fee for this service.

You can buy bonds from a broker, from a commercial bank, over the Internet, or (for Treasury securities) directly from the U.S. Treasury. Shares in bond funds can be purchased through a mutual fund or bond trust.

Monitoring your bond portfolio

Of course, you'll want to keep an eye on your bond portfolio, as you should with all of your investments. Although other factors may affect them, bond prices are often closely tied to interest rates. When rates go up, the market price of your bonds go down; when interest rates fall, your bonds rise in value.

Interest rates also tend to affect a bond's current yield, which measures the coupon rate of your bond in relation to its current price. The current yield rises with a corresponding drop in the price of a bond, and vice versa. In addition, inflation, corporate finances, and government fiscal policy can affect bond prices.

INVESTING IN STOCKS

Businesses sell shares of stock to investors as a way to raise money to finance expansion, pay off debt, and provide operating capital. Each share of stock represents a proportional share of ownership in the company. As a stockholder, you share in a portion of any

profits and growth of the company. Dividends from earnings are paid to shareholders, and growth is realized by the increase in value of the stock.

Stock ownership also generally gives you the right to vote on management issues. Company executives work for the shareholders, who are represented by an elected board of directors. The goal of management is to increase the value of the corporation's equity. If shareholders are dissatisfied with the corporation's performance, they can vote for a change in management.

Why invest in stocks?

The main reason that investors buy stock is for capital appreciation and growth. Although past performance is no guarantee of future results, stocks have historically provided a higher average annual rate of return than other investments, including bonds and cash equivalents. Correspondingly, though, stocks are generally considered to have more volatility than bonds or cash equivalents.

Can you lose money?

Yes, you can. There are no assurances that a stock will increase in value. Several factors can affect the value of your stocks:

Actions of investors: If a large number of investors believe that the nation is entering a recession, their actions can affect the direction of the stock market

Business conditions: A new patent, an increase in profits, a pending merger, or litigation could affect investor interest and stock prices

Economic conditions: Employment, inflation, inventory, and consumer spending influence the potential profit of a company and its stock price

Government actions: Decisions on interest rates, taxes, trade policy, antitrust litigation, and the budget impact stock prices

Global economy: Changes in foreign exchange rates, tariffs, or diplomatic relations can cause stocks to go up or down

Understanding these factors can help you make sound investment decisions and keep losses to a minimum.

What are the different classifications of stocks?

Stocks are often classified in the following ways:

Growth stocks have earnings that are increasing at a faster rate than their industry's average. These are usually in new or fast-growing industries and have the potential to give shareholders returns greater than those offered by the stocks

of companies in older, more established industries. Growth stocks are the most volatile class of stock, however, and are just as likely to go down in price.

Value stocks are those of companies with good earnings and growth potential that are currently selling at a low price relative to their intrinsic value. Due to some problem that may be only temporary in nature, investors are ignoring these stocks. Since it can take quite some time for their true value to be reflected by their price, value stocks are usually purchased for the long term.

Income stocks are generally not expected to appreciate greatly in share price, but consistently pay steady dividends. These are typically utilities, financial institutions, and other stable and well-established companies.

Blue chip stocks are the stocks of large, well-known companies with good reputations and strong records of profit growth. They also generally pay dividends.

Penny stocks are very risky speculative stocks issued by companies with short or erratic performance histories. These stocks are so named because they sell for under $5 per share. Their low price appeals to investors willing to assume a total loss in exchange for the potential of explosive growth.

It is usually best to diversify among the different classifications and not own stock in just one or two companies or industries.

How are stocks bought and sold?

During an initial public offering (IPO), new issues of stock are sold on the basis of a prospectus (a document that gives details about a company's operation) that is distributed to interested parties. Investment bankers or brokerage houses buy large quantities of the stock from the company and sell them to investors. After the IPO, the stock may trade on a stock exchange or over the counter.

Normally, stock is purchased through a brokerage account. The buy order you place will be directed to the appropriate stock exchange. When someone who owns the stock is willing to sell at the price you are willing to pay, the sale takes place. A commission or fee is charged on your transaction.

Stock certificates may be transferred from one owner to another since they are negotiable instruments. The certificates are issued in the buyer's name or, more typically, held by the brokerage house in the street name (i.e., the brokerage firm's name) on behalf of the investor. The advantage of a street-name registration is that if you decide to sell, you do not have to sign and deliver the stock certificates before the sale can be completed. And you don't have to worry about losing the stock certificates.

How do you set up a brokerage account?

You will need to complete a new account agreement and make three important decisions:

Who will make the investment decisions? You will--unless you give discretionary power to your broker or agent. Discretionary power allows a broker or agent to make decisions based on what he or she believes is best for you. Unless you limit the broker's or agent's discretion, this may be done without consulting you about the type of security and number of shares involved, or about the time and price at which to buy or sell. Do not give discretionary power to your broker or agent without seriously considering if it is right for you.

How will you pay for the stock? A cash account requires you to pay for each stock purchase in full at the time you buy it. A margin account allows you to borrow money from the brokerage firm. Securities that you own are held as collateral, and interest is charged on the loan. If the account value falls below the specified amount required to maintain the loan (even as the result of a one-day market decline), you must pay down the loan balance to an amount determined in relation to your new account balance. This is known as a margin call and can potentially require the payment of a sizable amount of money.

What level of risk can you handle? You will be asked to specify your investment goals in terms of risk. Choices such as income, growth, or aggressive growth may be given. Make sure you understand the meaning of each term, and be certain that the level of risk you choose truly reflects your ability to handle risk. Any investment your broker or agent recommends should be based on the category of risk you selected.

Read the account agreement

Never sign a document without reading and fully understanding it. Early precautions can prevent later misunderstandings.

Keep good records of:

Documents you sign Documents outlining the details of an account or investment Periodic account statements Transaction confirmations Documents verifying an account error was corrected Correspondence with your broker or agent

Review these as soon as you receive them. Discuss any discrepancies you find with your broker or agent at once, and follow up on any actions taken until you are satisfied. Never allow your broker or agent to mail statements and transaction confirmations to someone other than you. It's important that you check the accuracy of your own accounts.

Be patient

Some stock investors have made money quickly. But they are the exception rather than the rule. Investing in stocks requires a long-term outlook. Read books, attend seminars, and take advantage of professional advice. With education, good judgment, common sense, and above all, patience, you can be successful.

Market Capitalization

Market Capitalization

Market capitalization (market cap) measures company size. You can find a company's market cap by taking the current share price and multiplying it by the number of outstanding shares.

Micro Cap: Companies with market values under $300 million Small Cap: Companies with market values from $300 million to $1 billion Mid Cap: Companies with market values from $1 billion to $5 billion Large Cap: Companies with market values over $5 billion

A mutual fund with the name Small Cap, Large Cap, etc., invests primarily in companies that are in that range of market capitalization.

MUTUAL FUND BASICS

A mutual fund is a pool of money managed by a professional investment advisor on behalf of individual investors who have purchased shares of the fund. The fund manager buys securities to pursue a stated investment strategy. By investing in the fund, you'll own a piece of the total portfolio of securities, which could be anywhere from a few dozen to hundreds of stocks. This provides you with both a convenient way to obtain personal money management and instant diversification that would be harder to achieve on your own.

Types of mutual funds

There are many mutual funds to choose from. The two most common types are stock mutual funds and bond mutual funds. A stock fund invests in common stocks issued by U.S. and/or international companies. Funds are often named and classified according to investment style or objective, which can be stated in various ways. For example, some stock mutual funds buy stocks in those companies believed to have potential for long-term growth in share price. Other stock mutual funds look for current income by focusing on companies that pay dividends. Sector funds buy stocks in a particular sector, such as technology or health care. Still other mutual funds may purchase stocks based on the size of the company (e.g., stocks of large, midsize, or small companies).

Although the name of a stock mutual fund sometimes offers insight into its investment style and objective, it is important to not rely on the name alone in determining whether a

particular fund is what you want. The fund prospectus is like an owner's manual and contains information about the kind of investment style that the manager(s) employ, and the kinds of stocks that the fund will buy. You should read a fund's prospectus before you put money into it.

A bond fund is made up of debt instruments that governments or corporations issue to raise capital. They are designed to provide investors with interest income in the form of regularly scheduled dividends. If you bought individual bonds, you would need to concern yourself with their maturity dates and the reinvestment of your funds. Buying shares of a bond fund relieves you of these concerns; the fund manager handles them for you.

Bond funds are primarily classified according to the issuers of the bonds in the fund's portfolio and/or to the term of the bonds. For example, municipal bond funds buy bonds issued by municipalities. The income from these is free from federal tax (however, a portion of the income may be subject to the federal alternative minimum tax) and may be free from state and local taxes. Similarly, some funds invest only in U.S. Treasury debt instruments (e.g., bonds, bills, and notes) or high-grade (or low-grade) corporate bonds. Some bond funds, from all types of issuers, limit themselves to bonds maturing in the short, intermediate, or long term.

There are other types of mutual funds that you will encounter. Funds that invest in both stocks and bonds (or stocks, bonds, and cash equivalents) are often known as balanced funds. A money market fund buys extremely short-term debt instruments and is often used as a place to put cash, short term, until it is needed elsewhere. Index funds attempt to duplicate a standardized, broad-based index such as the Standard and Poor's 500 (S&P 500) stock index or Moody's bond index by holding a portfolio of the same securities used by the index in an attempt to match the index's performance as closely as possible.

What are the benefits of investing in a mutual fund?

Diversification: Most mutual funds own dozens or even hundreds of securities. The managers often spread the fund's assets over more than one type of investment (e.g., both stocks and bonds, and/or stocks from a variety of industries). This exposes you to less potential risk than buying just a few individual securities. If some of the fund's holdings perform poorly, they may be offset by others doing well.

Professional money management: Full-time expertise is part of what you pay for in buying shares of a mutual fund. The fund's manager analyzes hundreds of securities (both current and contemplated holdings) and makes decisions on what and when to buy and sell.

Small investment amounts: Depending on fund rules, you can open an account and make subsequent contributions with as little as $50. You can even set up automatic investments through a transfer of funds from your bank account.

Liquidity: You can convert your mutual fund investment into cash (i.e., redeem your shares) by making a request to the fund company in writing, over the phone, or on the Internet on any business day.

Of course, mutual funds are not guaranteed investments. The price of all mutual fund shares can change daily, and you'll receive the current value of your shares when you sell--which may be more or less than you paid.

Choosing the right fund for you

Choosing the right mutual fund to invest in requires more than picking a fund from the Top 10 list of the best past performers. Choosing a mutual fund requires careful thinking about numerous factors. The most important of these to consider include your investment objectives, risk tolerance, and time horizon.

Spend some time considering these factors, then do as much research as you can. Many financial magazines and websites are good sources of information to use in an initial screen for suitable mutual funds. Review the fund prospectus. It provides a great deal of information that you'll want to know about the fund, such as the fund's investment objective and style, and the fund's expenses. To get a prospectus, contact the mutual fund company directly, or go on-line to the company's website to download one.

Sales charge and other costs

All mutual funds have expenses that investors must pay for, but the sales charge, or load, is probably the most significant and varied among funds. These sales charges are generally paid as commissions to stockbrokers, financial advisors, and insurance agents. The sales charge may be deducted at the time you purchase shares of the mutual fund (front-end load), leaving less to work for you, or it may be charged at the point of redemption (back-end load). Some mutual funds, known as no-load funds, have no sales charges.

Pay attention to a mutual fund's other fees and expenses, as well. Look at a fund's expense ratio, which is calculated by dividing the fund's annual expenses by the fund's average net assets. Expenses impact a fund's return. The higher the expense ratio, the more likely the fund's return will be lower than a similar fund with lower expenses.

Turnover rate

Portfolio turnover reflects the average length of time that a security remains in a fund's portfolio. If a fund has replaced its entire portfolio during the course of the year, its turnover rate would be 100 percent.

Aggressively managed funds generally have higher portfolio turnover rates than do conservative funds, which buy and hold for the long term. High turnover rates generally add to the expenses of a fund because of the brokerage commissions paid for each transaction.

More important, however, is that when the fund sells stock at a gain, the gain must be distributed to shareholders. You will then be liable for income tax on your portion of the gain, even if the gain was reinvested, and even if your fund's share value actually decreased that year.

A tax-efficient approach minimizes the tax effect by implementing strategies such as offsetting gains by selling other stocks at a loss or holding stocks for long periods. Note that if you own a mutual fund in an individual retirement account (IRA) or a qualified retirement plan at work (e.g., a 401(k)), tax efficiency is not as important. This is because no tax is immediately paid on realized gains in these retirement accounts and plans; tax is deferred until the money is withdrawn.

Past performance

Although past performance is no guarantee of future results, a fund's track record over the past 3, 5, and 10 years is certainly worth considering. How does it compare with its peers--funds with similar risk and investment strategies? Apples-to-apples comparisons of funds are difficult, so a variety of broad market indexes are used as comparison benchmarks. For example, the S&P 500 is often used as a proxy for the U.S. stock market as a whole. Relative to the S&P 500, examine how well the fund that you are looking at has performed.

Fund managers

One of the advantages of purchasing mutual fund shares is professional money management. The past performance of the fund is a reflection of the fund manager's ability to effectively manage its assets. You should research the current manager's history with the fund; was the fund's performance his or her achievement? If the fund has a new manager, make sure that individual's investment style matches your expectations.

OTHER INVESTMENTS

A well-diversified investment portfolio contains a mix of stocks, bonds, short-term cash investments, and savings accounts that is tailored to your investment goals and risk tolerance. If you want to diversify your investment portfolio further, you can look to other investment options. Here are a few of these options, with brief explanations of what they are, how they can be used, and what the risks and potential rewards may be.

Precious metals

Many investors purchase silver or gold as a hedge against inflation or currency fluctuations.

In general, as inflation rises, the value of the dollar normally goes down. Historically, when a significant drop in the dollar occurred, gold and silver (and platinum to a lesser extent) went up in value. Precious metals such as gold had a tendency to retain their purchasing power no matter how badly the currency declined. Precious metals have intrinsic value, while currency can literally become worth less than the paper it is printed on, as was the case with the German mark after World War II. Keep in mind, though, that past performance is no guarantee of future results, and there can be no assurance that an investment will ever be profitable.

Like any other investment, risks are involved when investing in gold. These include certain risks uncommon to other types of investments, such as monetary policy changes and currency devaluations. Investors should discuss the risks of investing in gold with their financial professional.

If you want to invest in precious metals, you can actually purchase the asset (i.e., gold bullion or coins), invest in companies that mine the precious metal, or invest in a mutual fund that concentrates its portfolio in the securities of issuers principally engaged in gold-related activities.

Options

Options give the owner the right, but not the obligation, to buy or sell an underlying asset at a set price (strike price) before a certain date (expiration date). The underlying asset can be (to name the more popular ones) currency, a stock, a stock index, a bond, or a Treasury bill. A call option is the right to buy the underlying asset, and a put option is the right to sell the underlying asset. The price paid for the option is called the premium.

An investor purchases an option to control a specific number of shares for a limited period of time. An investor might purchase a call option because he or she believes that the price of the stock will go up during that period. Similarly, an investor might purchase a put option because he or she believes that the price will go down during that period. If the investor has guessed wrong, the option expires worthless and he or she could lose the total premium paid for the option.

An investor may sell an option for income on an underlying security that he or she owns. The income is the premium that an option buyer pays to purchase the option. If the underlying security moves in favor of the option buyer, the buyer may exercise the option, and the option seller may be required to sell the underlying security. If the

underlying security moves in favor of the seller, the buyer will normally not exercise the option, and the seller keeps both the premium and the underlying asset.

These are just two strategies in which an investor uses options. Although there are many benefits in using them, options are risky and not suitable for all investors. For example, selling an option is done in a margin account, subjecting the seller to interest costs and margin calls. It is important to discuss the role options can play in your portfolio with a financial professional.

Futures

A futures contract is a promise to buy or sell a commodity for a certain price on a future date. Commodities include many agricultural products such as farm grains, beef and pork products, and lumber. In addition to commodities, investors can trade futures on foreign currencies, interest rate products such as Treasury bills, precious metals, and market indexes such as the S&P 500.

Investors purchase futures contracts either as a hedge against price fluctuations or for speculation purposes. Hedging is the primary purpose of futures contracts. The purchaser of the futures contract establishes a price now for a purchase or sale that will take place in the future. Speculators buy and sell futures contracts based on what direction they expect prices to move; they hope to profit from the price changes that hedgers try to avoid.

Futures contracts are extremely high-risk investments. They should be considered only by experienced investors and professionals.

Real estate investment trusts

A real estate investment trust (REIT) is a corporation (or business trust) that invests in real estate or provides financing for real estate. REITs own and, in most instances, manage income-producing real estate such as offices, shopping centers, apartments, and warehouses. REITs derive their income from rents and capital gains realized on the sale of real estate. Some REITs invest in mortgages secured by real estate and get their income from the collection of interest.

REITs offer a convenient way for an investor to participate in commercial real estate. First, an investor's capital commitment is lower, since the investor buys shares of a REIT rather than the actual property. Second, owning REITs is more liquid than owning the property itself would be. Most REITs trade on the major stock exchanges and can be purchased or sold through stockbrokers. Finally, you get professional property management, which means you don't have to chase after the rents or respond to late-night phone calls about maintenance problems.

REITs offer long-term growth potential and income to an investment portfolio. Investing in REITs helps diversify a portfolio. However, risks are associated with real estate investing. The value of real estate is affected by interest rate changes, economic conditions (both nationally and locally), property tax rates, and other factors. It is important to discuss the role REITs can play in your portfolio with a financial professional.

THE BEST WAYS TO SAVE FOR COLLEGE

In the college savings game, all strategies aren't created equal. Should you choose a 529 plan, a Coverdell education savings account, or an UGMA/UTMA custodial account in your child's name? Or would you rather put your money in a mutual fund in your own name? Ideally, you'll want to choose a savings vehicle that offers you the best combination of tax advantages, financial aid benefits, and flexibility while meeting your overall investment needs.

529 plans: state savings plans

There are two types of 529 plans--state savings plans and prepaid tuition plans. Though each is governed under Section 529 of the Internal Revenue Code (hence the name "529" plans), state savings plans and prepaid tuition plans are very different college savings vehicles.

A state savings plan is a tax-advantaged college savings vehicle that lets you save money for college in an individual investment account. Some plans let you enroll directly, while others require that you go through a financial professional. The details of state savings plans vary by state, but the basics are the same:

You fill out an application--you are called the account owner or the participant. You name a beneficiary and a successor participant (who would assume control of the account at your death). You also choose one or more of the plan's pre-established investment portfolios for your contributions. Most plans offer a range of investment portfolios that vary in risk.

You (or someone else) contribute money to the account as often as you wish, subject to plan limits.

Your contributions fund the investment portfolios you've chosen--portfolios typically consist of groups of mutual funds.

The financial institution that the state has designated to run its plan is solely responsible for managing the plan's investment portfolios; you have no control over how these portfolios are run.

Your contributions grow tax deferred, which means you don't pay income tax on the account's earnings each year. Some states (but not the federal government) may also let you deduct your contributions.

Money withdrawn to pay college expenses (a qualified withdrawal) is tax free at the federal level, and may also be tax free at the state level.

If the money isn't used for college (a nonqualified withdrawal), you'll owe income tax and a 10 percent federal penalty on the earnings portion of the withdrawal.

Anyone can open a state savings plan account--your ability to contribute doesn't depend on your income or your status as a parent. Money in the plan can be used at any college in the United States or abroad that's accredited by the U.S. Department of Education. And, if your child decides not to go to college or gets a scholarship, the account can be transferred to a sibling or other qualified family member without penalty. Plus, if you're unhappy with your plan for any reason, you can switch (rollover) your funds to a different 529 plan (state savings plan or prepaid tuition plan) once every 12 months without penalty. Your state may even offer tax breaks too, like a deduction for contributions or tax-free withdrawals.

But state savings plans have drawbacks too. You relinquish some control of your money. Returns aren't guaranteed--you roll the dice with the investment portfolios you've chosen, and your account may gain or lose money. Also, there are fees typically associated with opening and maintaining an account (e.g., an annual maintenance fee, administrative fees, and investment expenses based on a percentage of total account value).

529 plans: prepaid tuition plans

Prepaid tuition plans are distant cousins to state savings plans--their federal tax treatment is the same, but just about everything else is different. A prepaid tuition plan is a tax-advantaged college savings vehicle that lets you prepay tuition expenses now for use in the future.

Prepaid tuition plans can be run either by states or colleges. For state-run plans, you prepay tuition at one or more state colleges; for college-run plans, you prepay tuition at the participating college(s). Although the details of prepaid tuition plans vary by state, the basics are the same:

You fill out an application--you are called the account owner or the participant. You name a beneficiary and a successor participant (who would assume control of the account at your death).

You (or someone else) purchase an amount of tuition credits or units in a lump sum or periodically, subject to plan rules and limits. Typically, the tuition credits or units are guaranteed to be worth a certain amount of tuition in the future, no matter how much college costs may increase.

Your contributions are pooled together with those of other participants into a general fund, and the money is invested. At a minimum, the plan hopes to earn an annual return equal to the annual rate of college inflation for participating colleges.

Your contributions grow tax deferred, which means you don't pay income tax on the account's earnings each year. Some states (but not the federal government) also let you deduct your contributions.

Money you withdraw to pay college expenses (a qualified withdrawal) is tax free at the federal level, and may also be tax free at the state level.

If the money isn't used for college (a nonqualified withdrawal), you'll owe income tax and a 10 percent federal penalty on the earnings portion of the withdrawal.

But prepaid tuition plans have drawbacks too. One major disadvantage is that your child is limited to the participating colleges--if your child attends a different college, plans differ on how much money you'll get back. Also, if the plan earns more than the relevant college inflation rate, you're not necessarily entitled to the difference. Keep in mind, too, that there are fees typically associated with opening and maintaining the account (e.g., an enrollment fee and administrative fees). Finally, money in a prepaid plan is treated less favorably than money in a state savings plan for purposes of federal financial aid (see financial aid section below).

Coverdell education savings accounts

A Coverdell education savings account (ESA) is a tax-advantaged education savings vehicle that lets you save money for college, as well as for elementary and secondary school (K-12) at public, private, or religious schools. Here's how it works:

You fill out an application at a participating financial institution and name a beneficiary. Depending on the institution, there may be fees associated with opening and maintaining the account. Keep in mind that the beneficiary of a Coverdell ESA must be under age 18 when the account is established (unless the beneficiary is a child with special needs).

You (or someone else) make contributions to the account, subject to the maximum annual limit of $2,000. This means that the total amount contributed for a particular beneficiary in a given year can't exceed $2,000, even if the money comes from different people.

You invest your contributions as you wish (e.g., stocks, bonds, mutual funds, certificates of deposit)--you have sole control over your investments.

Contributions to your account grow tax deferred, which means you dont pay income taxes on the account's earnings each year.

Money withdrawn to pay college or K-12 expenses (a qualified withdrawal) is tax free at the federal level, and typically at the state level too.

If the money isn't used for college or K-12 expenses (a nonqualified withdrawal), you'll owe income tax (at the beneficiary's tax rate) and a 10 percent federal penalty on the earnings portion of the withdrawal.

Any funds remaining in a Coverdell ESA must be distributed to the beneficiary when he or she reaches age 30 (unless the beneficiary is a person with special needs).

Unfortunately, not everyone can open a Coverdell ESA--your ability to contribute depends on your income. To make a full contribution, single filers must have a modified

adjusted gross income (MAGI) of $95,000 or less, and joint filers must have a MAGI of $190,000 or less.

Custodial accounts

Available even before the creation of 529 plans and Coverdell ESAs were custodial accounts. A custodial account allows your child to hold assets that he or she ordinarily wouldn't be allowed to hold in his or her own name. The assets can then be used to pay for college or anything else that benefits your child (e.g., summer camp, braces, hockey lessons, a computer). Here's how a custodial account works:

You fill out an application at a participating financial institution and name a beneficiary. Depending on the institution, there may be fees associated with opening and maintaining the account.

You also designate a custodian to manage and invest the accounts assets. The custodian can be you, a friend, a relative, or a financial institution. Keep in mind, though, that if a parent serves as custodian, the entire value of the account will be included in the parent's gross estate if the parent dies while serving as custodian.

You (or someone else) contribute assets to the account. Whether your state has enacted the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA) will determine the type of assets you are allowed to contribute (the UTMA allows more types of property than the UGMA, and most states have enacted the UTMA).

The account earnings are taxed every year at your child's tax rate. Assuming your child is in a lower tax bracket than you, you'll reap greater tax savings than if you had held the assets in your name. The opportunity for the greatest tax savings occurs once your child reaches age 14. However, while your child is under age 14, the kiddie tax rules apply, which means that any income over a certain threshold ($1,600 for 2004) is taxed at your rate, not your child's rate.

Despite the potential tax savings, custodial accounts have a serious drawback: all gifts to a custodial account are irrevocable. When your child reaches the age of majority (as defined by state law, typically 18 or 21), the account terminates and your child receives the money free and clear of parental influence. Some children may not be able to handle this responsibility, or might decide not to spend the money for college.

Financial aid impact

Your college saving decisions impact the financial aid process. Come financial aid time, your family's income and assets are run through a formula at both the federal level and the college (institutional) level to determine how much money your family should be expected to contribute to college costs before you receive any financial aid. This number is referred to as the expected family contribution, or EFC.

In the federal calculation, your child's assets are treated differently than your assets. Your child must contribute 35 percent of his or her assets each year, while you must contribute 5.6 percent of your assets.

For example, $10,000 in your child's bank account would equal an expected contribution of $3,500 from your child ($10,000 x .35), but the same $10,000 in your bank account would equal an expected $560 contribution from you ($10,000 x .056).

An UGMA/UTMA custodial account is classified as a student asset. By contrast, Coverdell ESAs and 529 state savings plans are considered parental assets if the parent is the account owner (so accounts owned by grandparents or other relatives or friends don't count at all). And distributions (withdrawals) from Coverdell ESAs and state savings plans that are used to pay the beneficiary's qualified education expenses are not classified as parent or student income on the federal government's aid form, which means that some or all of the money is not counted again when it's withdrawn. Other investments you may own in your name, such as mutual funds, stocks, U.S. savings bonds (e.g., Series EE and Series I), certificates of deposit, and real estate, are also classified as parental assets.

However, the federal government treats prepaid tuition plans more harshly for aid purposes than state savings plans. A prepaid tuition plan isn't classified as an asset of either parent or student on the aid application. But withdrawals are counted. Specifically, any distributions (withdrawals) from a prepaid tuition plan reduce your child's cost of attendance. The result is a reduction in your child's financial need--and thus financial aid--on a dollar-for-dollar basis. In other words, every dollar that comes out of your prepaid tuition plan will reduce your child's potential aid award by one dollar. (Most colleges treat state savings plans and prepaid tuition plans as parental assets--if the parent is the account owner--and withdrawals as student income.)

Legislative sunsets

The provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 that made qualified withdrawals from 529 plans tax free at the federal level, as well as the provisions that increased the annual contribution limit for Coverdell ESAs to $2,000, are scheduled to expire on December 31, 2010. Unless Congress acts, after this date, the federal treatment of 529 plans and Coverdell ESAs will revert to their status prior to January 1, 2002 (the earnings portion of qualified 529 plan withdrawals will be taxed at the beneficiary's tax rate, and the annual contribution limit for Coverdell ESAs will be $500).

UNDERSTANDING MUTUAL FUND SHARE CLASSES

When investing in a mutual fund, you may have the opportunity to choose among several share classes, most commonly Class A, Class B, and Class C. The differences among these share classes typically revolve around how much you will be charged for buying the fund, when you will pay any sales charges that apply, and the amount you will pay in

annual fees and expenses. This multi-class structure offers you the opportunity to select a share class that is best suited to your investment goals.

The costs associated with mutual funds

Mutual funds have costs that are passed on to investors. It's important for you to understand what the different costs are, since these are usually deducted from the money you've invested and can affect the return of your investment over time.

Typically, mutual fund costs consist of sales charges and annual expenses. The sales charge, often called a load, is the broker's commission, deducted from your investment when you buy the fund, or when you sell it. The annual expenses cover the fund's operating costs, including management fees, distribution and service fees (commonly known as 12b-1 fees), and general administrative expenses. They are generally computed as a percentage of your assets and then deducted from the fund before the fund's returns are calculated. (To better understand what these charges are, you should review the Fees and Expenses section of the fund's prospectus.)

So which share class should you choose? The answer to that depends on two factors: how much you want to invest and your investment time horizon.

Class A shares

Class A shares may appeal to you if you're considering a long-term investment of a large number of shares. When you purchase Class A shares, a sales charge, called a front-end load, is typically deducted upfront, thus reducing the actual amount of your initial investment. For example, suppose you decide to spend $35,000 on Class A shares with a hypothetical front-end sales load of 5 percent. You will be charged $1,750 on your purchase, and the remaining $33,250 will be invested.

However, Class A shares offer you discounts, called breakpoints, on the front-end load if you buy shares in excess of a certain dollar amount. Typically, a fund will offer several breakpoints, so the more you invest the greater the reduction in the sales load.

For example, let's say that a mutual fund charges a load of 5 percent if you invest less than $50,000, but reduces that load to 4.5 percent if you invest at least $50,000 but less than $100,000. This means that if you invest $49,000, you'll pay $2,450 in sales charges, but if you invest $50,000 (i.e., you reach the first breakpoint), you'll pay only $2,250 in sales charges.

You may also qualify for breakpoint discounts by signing a letter of intent and agreeing to purchase additional shares within a certain period of time (generally 13 months), or by combining your current purchase with other investment holdings that you or your spouse and children have within the same fund or family of funds (called a right of

accumulation). Since rules vary, read your fund's prospectus to find out how you may qualify for available breakpoint discounts, or contact your investment advisor for more information.

Class A 12b-1 fees tend to be lower than those of other share classes, thus reducing your overall costs. This may make Class A shares more attractive to you if you wish to hold on to the fund for a longer period of time.

Class B shares

Class B shares may appeal to you if you wish to invest a smaller amount of money for a long period of time. Unlike Class A shares, there is no up-front sales charge, so all of your initial investment is put to work immediately. Class B shares have a back-end load, often called a contingent deferred sales charge (CDSC) that you pay when you sell your shares. The load usually decreases over time (typically 6 to 8 years), although this varies from fund to fund. By the end of the time period no charge applies. At that stage your shares may convert to Class A shares.

For example, suppose you invest $5,000 in Class B shares, with a 5 percent CDSC that decreases by 1 percent every year after the second year. If you sell your shares within the first year, you will pay 5 percent of the value of your assets or the value of the initial investment, whichever is less. If you hold your shares for 6 years, the CDSC will be reduced to zero.

Before you purchase Class B shares, however, make sure that this investment fits in with your overall goals. Class B 12b-1 fees can be considerably higher than for Class A shares, so the cost of investing large amounts over time might be more than you would like. In addition, you don't benefit from the breakpoint discounts available with Class A shares, and you must pay the CDSC if you sell your Class B shares within the time limit. You should also keep track of when your shares convert to Class A shares, especially if your account has been transferred from one brokerage to another.

Class C shares

When you purchase Class C shares, a front-end load is normally not imposed, and the CDSC is generally lower than for Class B shares. This charge is reduced to zero if you hold the shares beyond the CDSC period, which for Class C shares is typically 12 months. For those reasons Class C shares may be appropriate if you have a large amount to invest and you intend to keep the fund for less than 5 years.

However, like Class B shares, the 12b-1 fees are greater for Class C shares than for Class A shares. Unlike Class B shares, these expenses will not decrease during the life of the investment, because C Class shares generally don't convert to Class A shares. In addition, there are no breakpoints available for large purchases.

Other options

Some mutual funds may not offer all three share classes and others may offer different classes, such as hybrid load shares or mid-load shares.

Another option you may consider is a no-load mutual fund that you can purchase directly from an investment company or through an investment advisor. As the name implies, these funds have no front-end or back-end loads, and their expenses are typically lower than for other share classes. Before you decide if these shares are suitable for you, you should look at their past performance and also at any expenses that may apply.

Do your homework Check out the mutual fund in advance. Read the prospectus carefully, especially

the discussion of fund classes and fees and how they apply to you. Make sure you understand how breakpoints work and how to take advantage of

them. Compare the fees and expenses of different fund classes, to see how purchasing

different share classes can affect your return. Take into account your investment amount, the length of time you plan to hold the fund, and the expenses and share load per share class.

Review your mutual fund holdings regularly. Keep yourself informed of possible upcoming deadlines, such as an impending breakpoint, or when any Class B shares you may own are scheduled to convert to Class A shares.

Keep your broker informed. To take advantage of all breakpoint discounts, you need to tell your broker about (a) your holdings within the mutual fund, and those of your family, (b) your holdings at other brokers, (c) any additional purchases you may have in mind.

For further information on mutual fund classes, log on to the website of the National Association of Securities Dealers (NASD) at www.nasd.com. You can also find information on the Securities and Exchange Commission (SEC) website at www.sec.gov.

As you consider how best to invest in mutual funds, keep in mind that there's no guarantee any mutual fund will achieve its investment objective. You should discuss all of your investment goals with a qualified financial professional.

ASSET ALLOCATION

Asset allocation is a common strategy that you can use to construct an investment portfolio. Asset allocation isn't about picking individual securities. Instead, you focus on broad categories of investments, mixing them together in the right proportion to match your financial goals, the amount of time you have to invest, and your tolerance for risk.

The basics of asset allocation

The idea behind asset allocation is that because not all investments are alike, you can balance risk and return in your portfolio by spreading your investment dollars among different types of assets, such as stocks, bonds, and cash equivalents.

Different types of assets carry different levels of risk and potential for return, and typically don't respond to market forces in the same way at the same time. For instance, when the return of one asset type is declining, the return of another may be growing (though there are no guarantees). If you diversify by owning a variety of assets, a downturn in a single holding won't necessarily spell disaster for your entire portfolio.

Using asset allocation, you identify the asset classes that are appropriate for you and decide the percentage of your investment dollars that should be allocated to each class (e.g., 70 percent to stocks, 20 percent to bonds, 10 percent to cash equivalents).

The three major classes of assets

Here's a look at the three major classes of assets you'll generally be considering when you use asset allocation.

Stocks: Although past performance is no guarantee of future results, stocks have historically provided a higher average annual rate of return than other investments, including bonds and cash equivalents. However, stocks are generally more volatile than bonds or cash equivalents. Investing in stocks may be appropriate if your investment goals are long-term.

Bonds: Historically less volatile than stocks, bonds do not provide as much opportunity for growth as stocks do. They are sensitive to interest rate changes; when interest rates rise, bond values tend to fall, and when interest rates fall, bond values tend to rise. Because bonds offer fixed interest payments at regular intervals, they may be appropriate if you want regular income from your investments.

Cash equivalents: Cash equivalents (or short-term instruments) such as money market funds offer a lower potential for growth than other types of assets but are the least volatile. They are subject to inflation risk, the chance that returns won't outpace rising prices. They provide easier access to funds than longer-term investments, and may be appropriate if your investment goals are short-term.

Not only can you diversify across asset classes by purchasing stocks, bonds, and cash equivalents, you can also diversify within a single asset class. For example, when investing in stocks, you can choose to invest in large companies that tend to be less risky than small companies. Or, you could choose to divide your investment dollars according to investment style, investing for growth or for value. Though the investment possibilities

are limitless, your objective is always the same: to diversify by choosing complementary investments that balance risk and reward within your portfolio.

Decide how to divide your assets

Your objective in using asset allocation is to construct a portfolio that can provide you with the return on your investment you want without exposing you to more risk than you feel comfortable with. How long you have to invest is important, too, because the longer you have to invest, the more time you have to ride out market ups and downs.

When you're trying to construct a portfolio, you can use worksheets or interactive tools that help identify your investment objectives, your risk tolerance level, and your investment time horizon. These tools may also suggest model or sample allocations that strike a balance between risk and return, based on the information you provide.

For instance, if your investment goal is to save for your retirement over the next 20 years and you can tolerate a relatively high degree of market volatility, a model allocation might suggest that you put a large percentage of your investment dollars in stocks, and allocate a small percentage to bonds and cash equivalents. Of course, models are intended to serve only as general guides. You may want to work with a financial professional who can help you determine the right allocation for your individual circumstances.

Build your portfolio

The next step is to choose investments for your portfolio that match your asset allocation strategy. If, like many other investors, you don't have the time, expertise, or capital to build a diversified portfolio of individual securities on your own, you may want to invest in mutual funds.

Mutual funds offer instant diversification within an asset class along with the benefits of professional money management. Investments in each fund are chosen according to a specific objective, making it easier to identify a fund or a group of funds that meet your needs. For instance, some of the common terms you'll see used to describe fund objectives are capital preservation, income (or current income), income and growth (or balanced), growth, and aggressive growth.

Pay attention to your portfolio

Once you've chosen your initial allocation, revisit your portfolio at least once a year (or more often if markets are experiencing greater short-term fluctuations). One reason to do this is to rebalance your portfolio. Because of market fluctuations, your portfolio may no longer reflect the initial allocation balance you chose. For instance, if the stock market has been performing well, eventually you'll end up with a higher percentage of your

investment dollars in stocks than you initially intended. To rebalance, you may want to shift funds from one asset class to another.

In some cases you may want to rethink your entire allocation strategy. If you're no longer comfortable with the same level of risk, your financial goals have changed, or you're getting close to the time when you'll need the money, you may need to change your asset mix.

CAN I AFFORD TO SEND MY CHILD TO COLLEGE?

It's the question every parent dreads. Although the answer hopefully is yes, you'll have to plan ahead. Unless you are very well off financially, you can't expect to sit on the sidelines for years and then suddenly find the funds to pay for college when your child is ready to go. The best thing to do is to start saving as early as possible, even if you're able to save only a small amount at first.

How much will college cost in the future?

For the 2003/2004 academic year, the average annual cost of a four-year public college is $13,833 and the average annual cost of a four-year private college is $29,541. (Source: The College Board's Trends in College Pricing Report 2003.) The total figures include five expense items: tuition and fees, room and board, books and supplies, transportation, and personal expenses.

It's a likely bet that costs will continue to rise, but by how much? During the last few years, college costs increased at an average rate of about 5 to 6 percent each year as colleges tried to control escalating costs. But going forward for the next 10 years, college costs are expected to increase a bit more, about an average of 7 or 8 percent per year. (Source: FinAid, 2002 report on college inflation, based on figures provided by The College Board and the Bureau of Labor Statistics.)

How will I pay for it?

Many parents save less than 100 percent of their child's education costs before college. Usually, they put aside enough money to make a down payment of sorts on the college bill. Then, at college time, parents can supplement this down payment by:

Obtaining private loans (e.g., home equity loan, margin loan) Obtaining financial aid-related loans (e.g., PLUS loan) Tapping their own investments (e.g., mutual funds, 401(k) plan, IRA, cash value

life insurance) Having their child apply for financial aid (e.g., student loans, grants, scholarships,

work-study) Having their child contribute a portion of his or her savings and/or investments

Having their child obtain a part-time job during college

How much should I save?

You'll want to put aside as much money as possible in your child's college fund. The more money you put aside now, the less you or your child will need to borrow later. Start by estimating your child's costs for four years of college. Then decide how much of the bill you want to fund--100 percent, 75 percent, 50 percent, and so on. To meet your goal, you'll need to use a financial calculator to determine how much to put in your college fund each month.

In many cases, the amount of money you should contribute really boils down to how much you can afford to contribute. Every situation is different. You'll need to take a detailed look at your family's finances in order to determine what you can afford to add to your child's college fund each month. To increase the amount of money that you're able to squirrel away, consider these options:

Cut back on nonessential spending Reduce your standard of living (e.g., own only one car, eat out less often) Add unanticipated windfalls like bonuses, raises, or an inheritance to your child's

college fund Have a previously stay-at-home spouse return to the workforce Obtain a new job with better pay Ask grandparents to contribute to your child's college fund in lieu of gifts

Start a savings program as early as possible

Perhaps the most difficult time to start a college savings program is when your child is young. New parents face many financial strains that always seem to take over--the possible loss of one income, child-related spending, the competing need to save for a house or car, or the demands of your own student loans. Yet this is the time when you should start saving.

With many years to go until your child starts college, you have time to select investments that have the potential to outpace college cost increases (but keep in mind that investments that offer higher potential returns may involve greater risk of loss). In addition, you benefit from compounding, which is the process of earning additional funds on the interest and/or capital gains that your investment earns along the way. With regular investments spread over many years, you may be surprised at how much you may be able to accumulate in your child's college fund.

But don't feel bad if you can't put aside hundreds of dollars a month right from the start. Start with a small amount, say $25 or $50 every month, and add to it whenever you can. You'll have a head start, as well as peace of mind knowing you're doing the best you can.

COMMON INVESTMENT GOALS

Go out into your yard and dig a big hole. Every month, throw $50 into it, but don't take any money out until you're ready to buy a house, send your child to college, or retire.

It sounds a little crazy, doesn't it? But that's what investing without setting clear-cut goals is like. If you're lucky, you may end up with enough money to meet your needs, but you have no way to know for sure.

How do you set investment goals?

Setting investment goals means sitting down and defining your dreams for the future. If you are married or in a long-term relationship, spend some time together discussing your joint and individual goals. You can do this on your own or with the help of a financial advisor. It's best to be as specific as possible. For instance, you know you want to retire, but when? You know you want to send your child to college, but to an Ivy League school or to the community college down the street?

You'll end up with a list of goals. Some of these goals will be long term (you have more than 15 years to plan), some will be short term (5 years or less to plan), and some will be intermediate (between 5 and 15 years to plan). You can then decide how much money you'll need to accumulate and which investments can best help you meet your goals.

Looking forward to retirement

After a hard day at the office, do you ask, "Is it time to retire yet?" Retirement may seem a long way off, but it's never too early to start planning--especially if you want retirement to be the good life you imagine.

Let's say that your goal is to retire at age 65 with $500,000 in your retirement fund. At age 25 you decide, with the help of an investment advisor, to begin contributing $250 per month to your tax-deferred 401(k) account. If your investment earns 6 percent per year, compounded monthly, you'll have more than $500,000 in your investment account when you retire.

But what would happen if you left things to chance instead? Let's say that you're not really worried about retirement, so you wait until you're 35 to begin investing. Assuming you contributed the same amount to your 401(k) and the rate of return on your investment dollars was the same, you would end up with only about half the amount you need.

Some other points to keep in mind as you're setting specific retirement investment goals:

Determine how much money you'll need in retirement: Many experts say that

you'll need about 75 to 85 percent of your current income to maintain your standard of living

Plan for a long life: According to life expectancy charts, you can expect to live for 15 to 20 years past retirement, assuming you retire at age 65

Think about how much time you have until retirement, then invest accordingly: For instance, if retirement is a long way off and you can handle some risk, you might choose to invest in stock or equity mutual funds that, though more volatile, offer a higher potential for long-term return than do more conservative investments

Consider how inflation will affect your retirement savings: When determining how much you'll need to save for retirement, don't forget that the higher the cost of living, the lower your real rate of return on your investment dollars

Facing the truth about college savings

Perhaps you faced the ugly truth the day your child was born. Or maybe it hit you when your child started first grade: You only have so much time to save for college. In fact, for many people, saving for college is an intermediate-term goal--if you start saving when your child is in elementary school, you'll have 10 to 15 years to build your college fund. Of course, the earlier you start the better. The more time you have before you need the money, the greater chance you have to build a substantial college fund due to compounding. With a longer investment time frame and a tolerance for some risk, you might also be willing to put some of your money into investments that offer the potential for growth.

Consider these tips as well:

Estimate how much it will cost to send your child to college and plan accordingly: Estimates of the average future cost of tuition at two-year and four-year public and private colleges and universities are widely available (or ask your financial advisor for information)

Research financial aid packages that can help offset part of the cost of college: Although there's no guarantee your child will receive financial aid, at least you'll know what kind of help is available should you need it

Look into state-sponsored tuition plans that put your money into investments tailored to your financial needs and time frame: For instance, most of your dollars may be allocated to growth investments initially, then later as your child approaches college, into more conservative investments to conserve principal

Think about how you might resolve conflicts between goals: For instance, if you need to save for your child's education and your own retirement at the same time, how will you do it?

Investing for something big

At some point, you'll probably want to buy a home, a car, or the yacht that you've always wanted. Although they're hardly impulse items, large purchases are usually not something for which you plan far in advance--one to five years is a common time frame.

Because you don't have much time to invest, you'll have to budget your investment dollars wisely. Rather than choosing growth investments, you may want to put your money into less volatile, highly liquid investments that have some potential for growth, but that offer you quick and easy access to your money should you need it.

DOLLAR COST AVERAGING

If you haven't started investing towards a long-term goal because you're worried about short-term market volatility, consider using a popular investment strategy called dollar cost averaging. Dollar cost averaging takes some of the guesswork out of investing in the stock market. Instead of waiting to invest a single lump sum until you feel prices are at their lowest point, you invest smaller amounts of money at regular intervals, no matter how the market is performing. Your goal is to reduce the overall volatility of your portfolio by purchasing more shares when the price is low and fewer shares when the price is high. Although dollar cost averaging can't guarantee a profit or protect against a loss in a declining market, over time your average cost per share is likely to be less than the average market share price.

How does dollar cost averaging work?

To illustrate how dollar cost averaging works, let's say that you want to save $3,000 each year for your child's college education. To reduce the risk of buying when the market is high, you decide to invest $250 in a mutual fund each month. As the following chart shows, this approach can help you take advantage of fluctuating markets because your $250 automatically buys fewer shares when prices are higher and more shares when prices are lower.

  Investment amount

Market price per share

Number of shares purchased

January $250 $10 25

February $250 $10 25

March $250 $11 22.72

April $250 $12 20.83

May $250 $11 22.72

June $250 $13 19.23

July $250 $14 17.86

August $250 $13 19.23

September $250 $14 17.86

October $250 $12 20.83

November $250 $10 25

December $250 $11 22.72

This chart is a hypothetical example and does not reflect the return of any specific investment.

If you calculate the average market price per share over the 12-month period ($141 divided by 12), the result is $11.75. However, if you calculate your average cost per share over the same period ($3,000 divided by 259 shares), you'll see that on average, you've paid only $11.58 per share.

Putting dollar cost averaging to work for you

You may not realize it, but if you're investing a regular amount in a 401(k) or another employer-sponsored retirement plan via payroll deduction, you're already using dollar cost averaging. In fact, you can use dollar cost averaging to invest for any long-term goal. It's easy to get started, too. Many mutual funds, 529 plans and other investment accounts allow you to begin investing with a minimal amount (e.g., $50), as long as you have future contributions deducted regularly from your paycheck or bank account.

If you're interested in dollar cost averaging, here are a few tips to help you put this strategy to work for you:

Get started as soon as possible. Once you've decided that dollar cost averaging is right for you, start investing right away. The longer you have to ride out the ups and downs of the market, the more opportunity you have to build a sizeable investment account over time.

Stick with it. Dollar cost averaging is a long-term investment strategy. Make sure that you have the financial resources and the discipline to invest continuously through all types of markets, regardless of price fluctuations.

Take advantage of automatic deductions. Having your investment contributions deducted from your paycheck or bank account is an easy and convenient way to invest, and can help you get in the habit of investing regularly.

RETIREMENT PLANNING--THE BASICS

You may have a very idealistic vision of retirement--doing all of the things that you never seem to have time to do now. But how do you pursue that vision? Social Security may be around when you retire, but the benefit that you get from Uncle Sam may not provide enough income for your retirement years. To make matters worse, few employers today offer a traditional company pension plan that guarantees you a specific income at retirement. On top of that, people are living longer and must find ways to fund those additional years of retirement. Such eye-opening facts mean that today, sound retirement planning is critical.

But there's good news: Retirement planning is easier than it used to be, thanks to the many tools and resources available. Here are some basic steps to get you started. When you're ready for more detailed planning, you can consult a financial professional.

Determine your retirement income needs

Many experts suggest that you need at least 60 to 70 percent of your preretirement income to enable you to maintain your current standard of living in retirement. But this is only a general guideline. To determine your specific needs, you may want to estimate your annual retirement expenses.

Use your current expenses as a starting point, but note that your expenses may change dramatically by the time you retire. If you're nearing retirement, the gap between your current expenses and your retirement expenses may be small. If retirement is many years away, the gap may be significant, and projecting your future expenses may be more difficult.

Remember to take inflation into account. The average annual rate of inflation over the past 20 years has been approximately 3 percent. (Source: Consumer price index (CPI-U) data published annually by the U.S. Department of Labor.) And keep in mind that your annual expenses may fluctuate throughout retirement. For instance, if you own a home and are paying a mortgage, your expenses will drop if the mortgage is paid off by the time you retire. Other expenses, such as health-related expenses, may increase in your later retirement years. A realistic estimate of your expenses will tell you about how much yearly income you'll need to live comfortably.

Calculate the gap

Once you have estimated your retirement income needs, take stock of your estimated future assets and income. These may come from Social Security, a retirement plan at work, a part-time job, and other sources. If estimates show that your future assets and income will fall short of what you need, the rest will have to come from additional personal retirement savings.

Figure out how much you'll need to save

By the time you retire, you'll need a nest egg that will provide you with enough income to fill the gap left by your other income sources. But exactly how much is enough? The following questions may help you find the answer:

At what age do you plan to retire? The younger you retire, the longer your retirement will be, and the more money you'll need to carry you through it.

What is your life expectancy? The longer you live, the more years of retirement you'll have to fund.

What rate of growth can you expect from your savings now and during retirement? Be conservative when projecting rates of return.

Do you expect to dip into your principal? If so, you may deplete your savings faster than if you just live off investment earnings. Build in a cushion to guard against these risks.

Build your retirement fund: Save, save, save

When you know roughly how much money you'll need, your next goal is to save that amount. First, you'll have to map out a savings plan that works for you. Assume a

conservative rate of return (e.g., 5 to 6 percent), and then determine approximately how much you'll need to save every year between now and your retirement to reach your goal.

The next step is to put your savings plan into action. It's never too early to get started (ideally, begin saving in your 20s). To the extent possible, you may want to arrange to have certain amounts taken directly from your paycheck and automatically invested in accounts of your choice (e.g., 401(k) plans, payroll deduction savings). This arrangement reduces the risk of impulsive or unwise spending that will threaten your savings plan--out of sight, out of mind. If possible, save more than you think you'll need to provide a cushion.

Understand your investment options

You need to understand the types of investments that are available, and decide which ones are right for you. If you don't have the time, energy, or inclination to do this yourself, hire a financial professional. He or she will explain the options that are available to you, and will assist you in selecting investments that are appropriate for your goals, risk tolerance, and time horizon.

Use the right savings tools

The following are among the most common retirement savings tools, but others are also available.

Employer-sponsored retirement plans allowing employee deferrals (401(k) plans) are powerful savings tools. Your contributions come out of your salary as pretax contributions (reducing your current taxable income) and any investment earnings grow tax deferred until withdrawn. These plans often include employer-matching contributions and should be your first choice when it comes to saving for retirement.

IRAs, like employer-sponsored retirement plans, feature tax-deferred growth of earnings. If you are eligible, traditional IRAs may enable you to lower your current taxable income through deductible contributions. Withdrawals, however, are taxable as ordinary income (unless you've made nondeductible contributions, in which case a portion of the withdrawals will not be taxable).

Roth IRAs don't permit tax-deductible contributions but allow you to make completely tax-free withdrawals under certain conditions. With both types, you can typically choose from a wide range of investments to fund your IRA.

Annuities are generally funded with after-tax dollars, but their earnings grow tax deferred (you pay tax on the portion of distributions that represents earnings). There is also no annual limit on contributions to an annuity. A typical annuity provides income payments beginning at some future time, usually retirement. The payments may last for your life,

for the joint life of you and a beneficiary, or for a specified number of years (guarantees are subject to the claims-paying ability of the issuing insurance company).

Note: In addition to any income taxes owed, a 10 percent premature distribution penalty tax may apply to distributions made from employer-sponsored retirement plans, IRAs, and annuities prior to age 59½ (prior to age 55 for employer-sponsored retirement plans in some circumstances).

How aggressive should I be when I invest for retirement?

Answer:

It depends. The right answer in your case will depend on a number of key factors. These include, among others, your income and assets, your attitude toward risk, whether you have access to an employer-sponsored plan at work, the age at which you plan to retire, and your projected expenses during retirement. But it's possible to lay down some guidelines that may be of help to you.

The conventional wisdom used to be that you should invest aggressively when you're young and then move gradually toward a more conservative approach. By the time you retired, you would probably end up with a portfolio made up mostly of high-grade bonds and other low-risk investments. This model may have worked at one time, but the retirement landscape has changed dramatically in the past 20 years or so. As a result, many of our basic assumptions about retirement planning have been overturned.

The dwindling number of traditional pension plans and concerns about Social Security have led people to take greater responsibility for their own retirement. Investing more aggressively over the long term has become common as people realize that, without anyone else to take care of them, they need to build the largest retirement nest egg they possibly can. In fact, many people these days primarily use growth vehicles (e.g., certain stocks and mutual funds) for their investment portfolios and tax-deferred retirement plans (e.g., 401(k)s and IRAs).

Other factors have changed the way we think about and invest for retirement as well. People tend to retire younger, live longer, and do more during retirement than they used to. With the likelihood that you will have well over 20 years of activity to fund, it's probably a good idea to invest more aggressively for retirement than previous generations did. And there's no reason to switch over to fixed-income securities upon reaching retirement. Many financial planners suggest that you keep a suitably balanced portfolio, including some of your assets in growth-oriented investments, even after you retire.

How do I construct an investment portfolio that's right for me?

Answer:

Generally, you should leave the construction of an investment portfolio to your professional investment advisor, especially if you are investing a significant percentage

of your total wealth, or if you're relying solely on the success of your portfolio to meet your future financial goals. However, whether you or your advisor designs your portfolio, consider a few of these well-recognized guidelines.

The term time horizon refers to how long you plan to keep your money invested. Your time horizon affects your portfolio design because the longer you plan to keep your money invested, the easier it is for you to ride out dips in the market. You may be able to tolerate more volatile investments, with potentially higher returns.

Your personal risk tolerance also affects your portfolio design. Can you sleep at night knowing that a sudden downward shift in the market could cost you a significant portion of your principal? If not, a portfolio that holds a high percentage of aggressive growth stocks, for example, is not right for you. You should match investments to your personal level of risk tolerance.

Your personal liquidity needs may eliminate some of your investment choices. If you periodically need access to your investment dollars, it makes no sense to design a portfolio with assets that can't be readily sold. Instead, you'll need investments that can be converted to cash easily and quickly.

How long should I hang on to an investment?

Answer:

You'll want to hang on to an investment as long as it meets your investment objectives, and you think it is likely to continue to perform as well as or better than comparable investments. Evaluating your investments once or twice a year will help you make that determination.

To evaluate your investments, you'll have to determine whether a particular investment is still appropriate for your age, risk tolerance, and financial goals. For example, perhaps you have been investing for retirement and have recently decided to purchase a home later this year. If a large part of your current investment portfolio is in a growth company stock fund, you should consider moving at least part of that investment to a less volatile investment, like a money market fund. Your investment goal has changed, and you'll need access to your investment dollars sooner rather than later. You certainly don't want to risk losing the down payment for your new home because of a sudden downturn in the markets.

A common mistake among investors is to hold on to an investment because it has fallen in value, hoping to earn your losses back before moving on. A good rule of thumb is that if you aren't willing to buy more of that investment at the lower value, it may be time to sell it. Just because the markets have historically gone up over time doesn't mean that an individual stock will go back up in value.

Aside from changes in your financial goals, a good time to re-evaluate an investment is when changes occur in the management of a mutual fund or company in which you own stock. You generally have no way of predicting what effect new management may have on the value of the securities. The additional risk or a change in investment objective, if any, may lead you to reconsider holding on to your shares.

Whenever you contemplate selling an investment, you may want to speak with a tax professional about the tax impact of the sale. You may decide to sell an investment that has performed poorly to offset gains in a given tax year. In contrast, you may want to hold on to an investment because selling it now may result in short-term capital gains treatment, whereas holding it for longer than a year will allow you to qualify for more favorable long-term capital gains treatment.

How much of my portfolio should I keep in stocks?

Answer:

Most professional planners advise that if you are saving for retirement, the younger you are, the more money you should put in stocks. Over the long term, stocks are more likely to provide favorable returns and capital appreciation than other commonly held securities. As you age, you have less time to recover from downturns in the stock market. Therefore, many planners suggest that as you approach and enter retirement, you should begin converting your more volatile growth-oriented investments to fixed-income securities such as bonds.

A popular rule of thumb is to subtract your age from 100. The difference represents the percentage of stocks you should keep in your portfolio. For example, if you are age 40, 60 percent (100 minus 40) of your portfolio should consist of stock. However, you may want to modify the result after considering other factors, such as your age, risk tolerance, and financial goals.

Investors are retiring earlier and living longer than in years past. For example, if you accept an early retirement package at age 57, it's feasible that you'll be living off your retirement fund for as long as 30 years or more. You'll have plenty of time for your portfolio to recover from any unexpected downturns in the markets, and with inflation and the rising costs of medical care, you will need more growth than what most fixed-income securities typically deliver. You may want to keep a significant portion of your portfolio invested in stocks well into your retirement years.

If you're investing for something other than retirement, the popular rule of thumb probably doesn't apply. If you'll need access to your investment dollars within a few years (e.g., to purchase a home or to pay your child's tuition), you should consider investing more of your portfolio in less volatile securities, such as money market or short-term bond mutual funds, rather than in stocks. If your investment goals are short term (e.g., two to five years), you won't have time to recover from a downward swing in the markets, and you risk that your investment dollars may not be there when you need them.

How should I structure my retirement portfolio?

Answer:

Your first step is to take advantage of tax-favored retirement savings tools. If you have access to a 401(k) or other employer-sponsored plan at work, participate and take full advantage of the opportunity. Open an IRA account and contribute as much as you can. Ideally, you'll be able to invest in both an employer plan and an IRA. Contributions to most employer plans are made on a pretax basis, while IRAs may allow for either tax-deductible contributions or tax-free withdrawals, depending on the type of IRA you choose. Plus, funds held in an employer plan or IRA grow tax deferred. These tax features may enable you to accumulate a sizable retirement fund, depending on how well the underlying investments perform.

With that in mind, you should aim for long-term investment returns and steady growth. Many financial planners suggest a balanced portfolio of stocks, bonds, mutual funds, and cash equivalents. The percentage of each will depend on your risk tolerance, your age, your liquidity needs, and other factors. However, the notion is fading that you should change your investment allocations and convert your entire portfolio to fixed income securities, such as bonds or CDs, by the time you retire. Instead, many planners now advise that you continue investing primarily for long-term growth even after you retire--especially since people are retiring younger and living longer on average. Your own personal circumstances will dictate the right mix of investments for you, and a qualified financial planner can help you make the right choices.

How can I gauge my risk tolerance?

Answer:

Risk tolerance is an investment term that refers to your ability to endure market volatility. All investments come with some level of risk, and if you're planning to invest your money, it's important to be aware of how much volatility you can endure. Your tolerance for risk affects your choice of investments and the overall makeup of your portfolio.

If you are attempting to gauge your own tolerance for risk, consider the following factors:

Personality: Are you able to sleep at night knowing that you've put a portion of your hard-earned dollars at risk in a particular investment? Remember, it might be easy to tolerate a high-risk investment while it is generating double-digit returns, but consider whether you'll feel the same way if the market takes a downward turn with your investment leading the way. It's best to pick investments with a level of volatility that you are comfortable with.

Time horizon: If you will need your investment dollars to make a down payment on a house in 2 years, your risk tolerance is lower than if you're investing for retirement in 20 years. If you can keep your money invested for a long period of time, you can ride out any downturns in the market. In general, the longer you can wait, the higher your risk tolerance.

Capacity for risk: How much can you afford to lose? Your capacity for risk depends on your financial position (i.e., your assets, income, and expenses). In general, the more you have to fall back on, the higher your risk tolerance.

In addition to the above, think about taking a risk tolerance test. Any number of risk tolerance tests can be found on the Internet and in books about investing. Most require that you answer a series of questions, and generate a score based on your answers. The score translates into a measure of your risk tolerance and may be matched with the types of investments that the author deems appropriate for someone with your risk profile. Although these tests may be helpful as a reference, an honest self-analysis and advice from a trusted professional financial advisor are still the best ways to determine what investment choices are best for you.

Is there any type of insurance that can protect against losses from investments?

Answer:

Although it may seem like you can buy insurance for just about anything nowadays, insurance companies do not currently offer protection against financial losses from poor investment choices or market downturns.

Perhaps you've heard people talk about portfolio insurance. This really isn't insurance at all. It's actually a complicated investment strategy that involves stock options and various other hedges in an attempt to protect a portfolio of investments against losses.

Should I invest my extra cash or use it to pay off debt?

Answer:

To answer this question, you must decide how your money can work best for you. Compare the money you might earn on other investments with the money you would pay on your debt. If you would earn less on investments than you would pay on debts, you should pay off debt.

Let's assume that you have $1,000 in a savings account that earns an annual rate of return of 4 percent. Meanwhile, your credit card balance of $1,000 incurs annual interest at a rate of 19 percent. Your savings account thus earns $40, while your credit card costs $190. Your annual net loss is 15 percent, or $150, the difference between what you earned on the savings account and what you paid in interest on the credit card balance. It's even worse when you consider the tax effect. The interest on the savings account is taxable, and you have to use after-tax dollars to pay your credit card bill.

In this instance, it would be best to use your extra cash to pay down the high-interest debt balance. The same principle would apply if you were to invest your extra cash in a certificate of deposit (CD), mutual fund, or other investment.

Now, let's look at another example. Say you have a student loan of $1,000 that you are repaying at an annual interest rate of 5 percent. Instead of paying off the debt, you invest $1,000 in a CD earning a 7 percent average rate of return.

Here, your best strategy would be to keep the loan and invest the extra cash, because your net gain will be 2 percent annually, or $20--the difference between what you earned on the investment, less what you paid on the debt.

What is asset allocation and how does it work?

Answer:

Asset allocation is a technique used to spread your investment dollars across several asset categories. The investment categories may include cash equivalents, bonds, stocks, real estate, mutual funds, insurance products, or any other investment category imaginable. The general goal is to minimize volatility while maximizing return. The process involves dividing your investment dollars among asset categories that do not all respond to the same market forces in the same way at the same time. Ideally, if your investments in one category are performing poorly, you will have assets in another category that are performing well. The gains in the latter will offset the losses in the former, minimizing the overall effect on your portfolio.

The number of asset categories you select for your portfolio and the percentage of portfolio dollars you allocate to each category will depend, in large part, on the size of your portfolio, your tolerance for risk, your investment goals, and your time horizon (i.e., how long you plan to keep your money invested). A simple portfolio may include as few as three investment categories, with a percentage of total dollars divided among, for example, cash equivalents, bonds, and stocks. A more complex portfolio may include many more asset categories or break down each of the broader asset categories into subcategories (e.g., the category "stocks" might be further divided into subcategories such as Large Cap stocks, Small Cap stocks, international stocks, high-tech stocks, and so on).

Generally, the asset allocation that best suits your needs is determined with the help of a professional financial advisor. (Instant asset allocation can be achieved by investing in an asset allocation mutual fund.) Whether you hire a professional advisor or not, be sure to periodically review your portfolio to ensure that the mix of investments you have chosen still serves your investment needs.

What is dollar cost averaging and how do I know if it's right for me?

Answer:

Dollar cost averaging is a method of accumulating assets by purchasing a fixed dollar amount of securities, in regularly scheduled intervals, over a period of time (e.g., $100 per month over the next five years). When the price of the securities is high, your fixed dollar amount will buy fewer securities, but when the price of the securities is low, your

fixed dollar amount will buy more. For example, when your share price is $25 you will purchase four shares, but when the price drops to $20 you will buy five shares. This allows you to take advantage of the fluctuations in the market. Historically, the markets have always gone up over the long term. As a result, dollar cost averaging with a fixed dollar amount should yield a lower average per share price than if you bought a fixed number of securities for each periodic interval.

Note: 401(k) contributions are a good example of dollar cost averaging, because they are deducted from each of your paychecks and then sent to the investment company.

Dollar cost averaging is often favored by those who wish to make their periodic investment a part of their monthly budget. The amount invested each month is predictable. An automatic investment plan (e.g., a systematic electronic draft from your checking account) will ensure that the predetermined amount is properly invested at appropriate intervals. Among other things, this relieves you of the concern and emotional burden that comes with trying to decide when, and how much, you should be investing when the price of your securities is rising or falling. Experts suggest that this strategy works best with a single investment vehicle that regularly fluctuates in price, such as a growth mutual fund.

What's the difference between growth investing and value investing?

Answer:

When you invest for growth, you are typically seeking capital appreciation over the long term. You will likely choose investments that you believe will exhibit a faster-than-average increase in share price over the coming years. Growth stocks have the potential to outperform slower-growing investments, such as income stocks, because gains are generally reinvested in the company to achieve further growth rather than distributed to shareholders as a dividend. Growth stocks can be volatile. One way to minimize the effects of volatility in your portfolio, and avoid shopping for individual growth stocks, is to purchase shares of a growth mutual fund. You'll enjoy professional management and instant diversification.

If you are a value investor, you choose investments that have low prices in relation to such factors as earnings, sales, net current assets, and the book value of the issuing companies. You consider these investments to be bargains. A value investor might reject a popular blue chip stock because the price per share is too high, even though the issuing company is stable and has a record of steady growth. Instead, the value investor seeks to buy stock of a solid company that is temporarily out of favor or bargain priced for some other reason. In doing so, the value investor predicts that the share price will eventually return to a higher level when the stock comes back into favor, and the market drives the stock price back up. Some mutual funds specialize in value investing if you want to diversify and avoid picking individual stocks.

Is it better to invest in a tax-free or a taxable mutual fund?

Answer:

Typically, a tax-free mutual fund is made up of municipal bonds and other government securities. Such securities are attractive to many investors because returns are tax free, often at both the state and federal levels. However, they also tend to provide lower pretax returns than comparable securities issued by nongovernmental entities. It is imperative that you consider total after-tax returns when you are comparing a tax-free fund with a taxable fund. Whether or not a taxable fund is a better choice for you will depend in large part on how much of your returns are likely to go directly to federal, state, and local taxes at the end of the year.

To determine your after-tax rate of return on a taxable investment, multiply your rate of return by 100 percent minus your tax rate:

Pretax return x (100% - tax rate) = After-tax rate of return

For example, say you are in the 25 percent tax bracket and earn a pretax return of 10 percent on an investment. Your after-tax rate of return would be 7.5 percent, calculated as follows:

10% x (1 - .25) = .075 or 7.5% after-tax rate of return

In addition, consider whether the fund will be held in a qualified pension or retirement plan. If your returns will automatically accumulate tax deferred in an IRA or 401(k), there may be no reason to accept lower returns in exchange for a tax-free feature.

If you are risk averse, you may decide on a tax-free fund. The securities that it holds will be backed by the full faith and credit of the issuing bodies, be they the federal government, the state government, or a municipality. This feature gives some investors an added degree of assurance on top of the tax-free feature.

Should I invest in mutual funds or individual securities?

Answer:

Mutual funds offer many advantages that are particularly attractive if you have a small amount to invest (i.e., $25,000 or less), or if you don't have the time, experience, or inclination to manage your own investment portfolio. Mutual fund managers are professional buyers and sellers of securities. If you invest in a mutual fund, you get the benefit of their professional money management without the expense of hiring your own investment advisor (although you'll pay mutual fund fees and expenses).

Money invested in a mutual fund is fairly liquid. With some qualifications, you can sell your shares back to the issuer at any time if you need cash. Also, the typical mutual fund holds dozens and often hundreds of different securities. If you purchase shares of a

mutual fund, you benefit from instant diversification. For instance, if you buy into an asset allocation fund, your investment dollars will automatically be spread across multiple asset categories, even if you invest only a few hundred dollars. It would require a much larger initial outlay of cash to purchase a portfolio of individual securities as diverse as most mutual funds.

However, investing in individual securities also has its advantages. You can time the purchase and sale of securities to minimize the tax consequences. You can hold securities long enough to avoid short-term capital gains treatment and realize your losses at a time when you are in the best position to claim them as a deduction. As a mutual fund investor, you give up that control--fund managers do not consult with shareholders before making transactions. Finally, although you may spend more time and money building a portfolio of individual securities, you'll be able to customize your portfolio so that it truly serves your needs. You can invest only in companies you are comfortable investing in, with the level of diversification you desire and degree of risk you're willing to take.

What is a mutual fund prospectus and how do I read it?

Answer:

A mutual fund prospectus is a pamphlet or brochure that provides information about a mutual fund. Mutual fund companies must give potential investors a prospectus, free of charge, before they invest. You can get a prospectus by calling the mutual fund company directly or by visiting the fund's website. Once you receive the prospectus, read it carefully and completely.

The prospectus will include information about the fund manager's objectives and practices. When reviewing a prospectus, you'll want to look at the kind of securities the fund holds and the kind of transactions it makes and how often. Make sure the fund operates in a way that's consistent with your own needs, investment goals, and tolerance for risk. For instance, if you need to invest for income and preservation of capital, and the prospectus describes the fund's investment policy as aggressive and growth oriented, then you haven't found a good match.

The prospectus will also tell you about expenses and fees. It will disclose specifics about sales charges and fees for management, distribution (12b fees), redemption, reinvestment, and exchange transactions that may be charged to you as a shareholder. It will also disclose the minimum required investment amounts and whether the fund is a load or no-load fund. Before you invest, gather this information from the prospectus so that you understand the cost of investing in the fund.

What is the difference between an open-end and a closed-end mutual fund?

Answer:

Both open-end and closed-end mutual funds comprise a portfolio of securities (such as stocks and bonds) that is managed by a professional money manager. If you wish to invest in the fund, you buy shares. Basically, however, that is where the similarities end.

A key difference between the two types of funds is that the number of outstanding shares of an open-end fund can vary dramatically from day to day, whereas shares of a closed-end fund are fixed in number. An open-end fund will issue new shares, or repurchase old shares, as needed to meet investor demand, depending on whether money is being added to the fund or shares are being redeemed. The per share price is determined by the net value of all assets held by the fund, divided by the number of shares.

As mentioned, a closed-end fund has a fixed number of shares. You don't purchase new shares from the fund; instead, you purchase existing shares from other investors. Shares are typically traded on an open market (stock exchange) where they sell at either a premium or a discount, depending on demand.

Open-end funds are by far the most popular among typical investors. With an open-end fund, you can participate in the markets and have a great deal of flexibility regarding how and when you purchase shares. Also, you are never required to purchase shares at a premium. Closed-end funds are typically more volatile and behave more like individual stocks. You need to buy them through a broker, and if you want out (or in), you are bound by whatever price the market bears.

Are government savings bonds risk free?

Answer:

Government savings bonds are generally deemed risk free because they are backed by the full faith and credit of the federal government. Most investors feel confident that the U.S. government will not default on its obligations to bond holders. However, there are other types of risk to consider.

Perhaps the biggest risk you face when buying government savings bonds is inflation risk. Most savings bonds have interest rates that are pegged to other government securities and are not adjusted for inflation (the exception is Series I bonds that are adjusted semiannually for inflation). As inflation goes up, the spending power of your dollars goes down. With government securities, there is always the risk that inflation will outpace your rate of return, effectively diminishing the spending power of your savings.

Interest rate risk is also a factor. For example, Series EE savings bonds are not currently issued with a specified interest rate. Instead, their interest rate is pegged to an average yield of other government securities. Your return, and your risk, is directly tied to how those government securities perform. If interest rates go down, your returns will be affected.

Are savings bonds a good way to save?

Answer:

Savings bonds may or may not be the best way for you to save. It depends in large part on your savings goals and needs. Savings bonds are backed by the full faith and credit of the U.S. government. As such, they are generally deemed very safe investments. In addition, savings bonds are readily available and can be exchanged at most banks. They are also available through payroll deduction plans and automatic purchase plans. Moreover, interest earned on savings bonds is exempt from state and local taxes. In some cases, interest income may also be exempt when the proceeds are used for educational expenses. In short, if you have low tolerance for risk and want a tax-advantaged savings vehicle that is both liquid and simple to administer, you should definitely consider savings bonds.

Savers who shun savings bonds argue that it is difficult to calculate the value of savings-bond interest rates. Multiple rate schedules, interest rates pegged to other government securities, and yet-to-be-determined rate structures make it difficult for most consumers to calculate how much they are earning on their investments and how much "savings" they have accumulated on any given date. Moreover, most savings bonds will not protect you from inflation (Series I bonds are the exception, with semiannual adjustments for inflation). Finally, your savings bonds cannot be sold or used as collateral for a loan.

Do Series EE bonds offer any special advantages if used for college savings?

Answer:

Yes. Series EE bonds (which may also be called Patriot bonds) are generally inexpensive, low-risk investments whose earnings are exempt from state and local taxes. In addition, in the college savings game, the interest earned by Series EE bonds (and Series I bonds) may be exempt from federal tax if the following requirements are met:

The bond must be issued in the name of one or both parents (not the child's name), and the owner of the bond must be at least 24 years old

The bond proceeds must be used to pay qualified higher education expenses (generally tuition and fees, not room and board)

The bond must be redeemed (cashed in) by the owner in the year it's used to pay the qualified education expenses of the owner, the owner's spouse, or their child

You must file a joint tax return if you're married You must fall under established income limits (these limits are adjusted annually

for inflation)

If you meet these requirements, you'll pay no federal tax on the interest earned by the bond when you cash it in. This saved amount can then be applied to the college bill.

However, despite this potential tax advantage, Series EE bonds have some disadvantages. They have relatively low growth potential in an arena where it's crucial to keep up with

annual college cost increases. Also, because the federal government changes interest rates often, it may be difficult to ascertain your bond's present worth or exactly what it is earning at any given time.

Should I invest in mutual funds or individual securities?

Answer:

Mutual funds offer many advantages that are particularly attractive if you have a small amount to invest (i.e., $25,000 or less), or if you don't have the time, experience, or inclination to manage your own investment portfolio. Mutual fund managers are professional buyers and sellers of securities. If you invest in a mutual fund, you get the benefit of their professional money management without the expense of hiring your own investment advisor (although you'll pay mutual fund fees and expenses).

Money invested in a mutual fund is fairly liquid. With some qualifications, you can sell your shares back to the issuer at any time if you need cash. Also, the typical mutual fund holds dozens and often hundreds of different securities. If you purchase shares of a mutual fund, you benefit from instant diversification. For instance, if you buy into an asset allocation fund, your investment dollars will automatically be spread across multiple asset categories, even if you invest only a few hundred dollars. It would require a much larger initial outlay of cash to purchase a portfolio of individual securities as diverse as most mutual funds.

However, investing in individual securities also has its advantages. You can time the purchase and sale of securities to minimize the tax consequences. You can hold securities long enough to avoid short-term capital gains treatment and realize your losses at a time when you are in the best position to claim them as a deduction. As a mutual fund investor, you give up that control--fund managers do not consult with shareholders before making transactions. Finally, although you may spend more time and money building a portfolio of individual securities, you'll be able to customize your portfolio so that it truly serves your needs. You can invest only in companies you are comfortable investing in, with the level of diversification you desire and degree of risk you're willing to take.

Should I work with a stockbroker to buy individual stocks?

Answer:

This is almost a trick question, because in order to buy an individual stock on an exchange, you must always go through a brokerage house that is a member of that exchange, and the transaction will be completed by a registered broker. Perhaps the more important question is whether you should use a full-service broker, a discount broker, or some combination of the two.

If you have more money than time to manage it, you may find the full-service broker well worth the additional expense. Full-service brokers typically charge a fee or commission but provide research, individual planning assistance, and investment advice. Many full-

service brokers also offer the option of using mutual funds for some part of your investment portfolio. Typical discount brokers may provide little or no investor services but can charge much less to complete whatever transactions you desire.

Competition for market share and advances in technology have given rise to a whole host of brokerages that combine the elements of these two extremes. Most notable are the Internet brokers that feature on-line research and assistance, as well as low-cost, per-trade, flat rates. Whatever broker you choose to work with, make sure you know what you are getting and how much you are paying for it, before you invest.

What are DRIPs?

Answer:

When you own stock in a company, you may have the option to participate in a dividend reinvestment program (DRIP). A DRIP automatically reinvests your shareholder dividends in more shares of the same company's stock. When you are due a dividend, you are issued more shares of stock instead of a cash dividend payment. In some cases, the issuing company will cover the broker's fees and may even provide the additional shares at a discounted price. That means you get more bang for your investment buck. These plans allow companies to raise capital without conducting a new public offering of securities.

In addition to those bonuses, you benefit by accumulating shares in the company automatically and incrementally over the long term. In that regard, DRIPs have advantages similar to those provided by automatic investment plans. Periodically, a portion of your income (in this case, dividend income) is automatically invested without the need for you to make a separate investing decision each time.

DRIPs also have some advantages similar to those of dollar cost averaging plans. Your investments are made periodically so that you can take advantage of fluctuations in the market and hopefully achieve an overall lower average share price than if you made a one-time investment. Remember, to achieve the advantages of a diversified portfolio, you do not want to invest all of your savings in only one DRIP. By investing in a number of DRIPs offered by different companies in various industries, you can reduce your portfolio's exposure to the risk that shares of one of the companies will decline in value.

What is a stock split?

Answer:

When a company splits its stock, it takes each share and divides it into some larger number of shares. It can be a 2-for-1 stock split or any other combination. When the stock is split, more shares are available, but the total value of all the shares remains the same. Accordingly, if you owned one share worth $100, and the issuing company conducted a 2-for-1 stock split, you would own two shares worth $50 each. Companies can also do

reverse splits, making one share from numerous shares, if they want to increase the per-share price of the stock.

Stock splits are typically done when the price of individual shares has risen to a level that the company feels is higher than optimal. More affordable share prices are thought to increase liquidity, or the ease with which shares are bought and sold. Companies also split their stock to show the confidence of management in the future performance of the stock and to attract attention to the stock if it has been languishing. Although studies have been conducted on whether stocks that split perform better than those that don't, evidence suggests that splits make little difference in stock performance over the long term.

Who do I call if I have a complaint about my stockbroker?

Answer:

First of all, you'll have to act promptly. By law, you have only a limited amount of time to take legal action. You'll need to contact your broker first and give him or her the chance to correct the problem. If the broker can't or won't help you, you'll need to take further steps.

You should review the documents you signed when you opened your account. They should describe your appeal process. You should contact the broker's branch manager or regional office manager. Often they will have the authority to intervene and resolve the matter. If not, write to the compliance department of the firm's main office. Explain the problem clearly and tell them how you want it resolved. Ask for a written response within 30 days. Keep thorough notes on each of your conversations, including dates and who you contacted. It is also a good idea to follow up a phone call with a letter.

If you still get no satisfaction, you may want to contact any of the regional or district offices of the United States Securities and Exchange Commission (SEC) to get information about how to file a complaint with any of the offices that oversee the securities industry. The SEC has offices in New York, Boston, Philadelphia, Miami, Atlanta, Chicago, Denver, Fort Worth, Salt Lake City, Los Angeles, and San Francisco. You can also file complaints on-line at the SEC's website (www.sec.gov) or by writing to the SEC Complaint Center, Securities and Exchange Commission, 450 Fifth Street NW, Washington, DC 20549.

Finally, if all other efforts have failed, contact your attorney. Your problem may involve criminal behavior or require a securities specialist.

How did the Jobs and Growth Tax Relief Reconciliation Act of 2003 change capital gains tax rates?

Answer:

If you sell or exchange a capital asset for more than your adjusted basis in the asset, the result is a capital gain. The Jobs and Growth Tax Relief Reconciliation Act of 2003

reduced the maximum tax rate on most long-term capital gains (those held for longer than 12 months) and eliminated the "super" long-term capital gains rates on the sale of assets held longer than five years. The reduced rates apply to sales and exchanges made on or after May 6, 2003 and before January 1, 2009.

The 20 percent individual rate on long-term capital gains was reduced to 15 percent for individuals in a marginal income tax bracket greater than 15 percent

The 10 percent individual rate on long-term capital gains was reduced to 5 percent for individuals in the 10 or 15 percent marginal income tax bracket (the 5 percent rate will become 0 percent in 2008)

The reduced capital gains rates apply for both regular income tax and alternative minimum tax (AMT) purposes.

For information on how you might be affected by the reduction in capital gains rates, consult a tax professional.

I have investment property. What does basis mean, and how do I determine the basis of my property?

Answer:

To determine your basis in an asset for purposes of calculating capital gain or loss upon the sale or other disposition of the property, you need to understand two terms--initial basis and adjusted basis.

Often, your initial tax basis equals your cost--what you paid for the asset. For example, if you purchase one share of stock for $10,000, your initial basis in the stock will equal $10,000. However, your initial basis can differ from the cost if you did not purchase an asset, but rather received it as a gift, as an inheritance, or in a tax-free exchange.

It's also important to understand the concept of adjusted basis. Your initial basis in an asset can increase or decrease over time. For example, if you buy a house for $100,000, your initial basis in the house will be $100,000. If you later improve your home by installing a $5,000 deck, your adjusted basis in the house may be $105,000. You should be aware of which items increase the basis of your asset, and which items decrease the basis of your asset.

To calculate a capital gain or loss, you need to know your adjusted basis in the asset. Essentially, capital gain or loss equals the amount you realize on the sale of your asset minus your adjusted basis in the asset.

Will I have to pay tax on my investment income?

Answer:

The taxation of your investment income depends on several factors, including the type of investment income you have (e.g., tax exempt, ordinary, capital gain, or tax deferred).

If you have municipal bonds, the interest they generate is typically exempt from federal taxation and state taxation in the state the bonds are issued. The interest may or may not be subject to state income tax in the state of your residence, if different from the state of issue. U.S. Treasury bills and certain types of government savings bonds generate interest that is typically subject to federal tax, but not state tax.

Of course, not all investments are tax exempt. Investment income is generated by either the income it produces during the ownership of the investment (e.g., interest, dividends, or rent) or the gain it produces when the investment is sold at an appreciated value. Investment income such as interest, dividends, or rent is considered ordinary income and will generally be taxed according to your ordinary income tax rate. If you have investment income from the sale of a capital asset that is held for more than one year (e.g., stock or investment property), the income is generally considered capital gain and is taxed at a capital gain rate based upon the type of asset and how long you held it.

Finally, you should know that tax-deferred investments (such as 401(k) plans) produce earnings and gains that are not taxed until later, when the money is distributed to you.

For more information, consult a tax professional.