Round Three

This week we'll define some more finance terms, but first let's review a headline from the past few days.

You have likely heard that George H.W. Bush passed away on Sunday. What you may not have heard is that the stock market will be closed tomorrow as part of a national day of mourning for the former president.

The stock and bond markets traditionally close following the passing of former presidents and vice presidents, but they have also closed for a host of other reasons, such as blizzards, coronations and funerals of kings and queens, the beginnings and endings of World Wars 1 and 2, and in August of 1917 for "heat". And of course, the market was closed for four days following the September 11th terrorist attacks.

There have also been partial closings for local traffic jams and computer system malfunctions, and whole days off to allow office staff to catch up after heavy trading during the Great Depression. A list of historical NYSE closures reminds me that with all the technology underpinning global markets these days, they're still fundamentally human institutions.

Continuing our theme from the past two weeks, here are two more finance terms from the YouGov report that roughly 60% of Americans profess to know little about: Roth IRA and Annuity. Entire books have been written about these terms, but I'll do my best to condense the definitions down to a few short paragraphs.

Roth IRA – Started in 1997 as part of the Taxpayer Relief Act and named after the bill's chief sponsor, Senator William Roth, a Roth IRA is a type of account used to save money that will ultimately be tax-free during retirement.

The deal with Roth IRAs is that you can deposit money each year ($5,500 this year going up to $6,000 next year, plus a $1,000 catch-up if you're 50 or over) and invest in stocks, bonds, mutual funds, CDs, whatever you want. If the money grows over time you can take the money out of the account when you're retired and pay no tax on the gains you've made.

Say you deposit $5,000 and the money grows to $10,000 over ten years. Then say you'd like to take a trip to Europe with your spouse to celebrate the two of you finally retiring. You cash in the Roth IRA, withdraw the $10,000, but pay zero tax on the $5,000 of profit.

How is this possible? The government gives you a pass on the taxable gain because they want to stimulate retirement savings. You didn't ask for anything up front, such as a tax deduction (that's the other kind of IRA), so the carrot they provide to get you to save is tax-free growth.

The longer you have until retirement, the more we want to leverage Roth IRAs. Longer, because investments in the Roth need time to grow and, without growth, having a Roth IRA is pointless.

Annuity – At its most basic, an annuity is a consistent cashflow, backed by a strong third party (such as an insurance company), that you pay for in advance.

Say you're a 65-year-old retiree thinking about a steady source of income that's not tied to the stock or bond markets. You send a lump sum of cash to an insurance company and they in turn start sending you a check every month for as long as you live

How much could you hope to get these days? A 65-year-old women could expect to spend around $100,000 to receive about $530 per month for life. If you do the math this seems like a return of 6.4% per year. Sounds pretty good, right?

Well, here's the catch with annuities. The insurance company is basically returning your money back to you, little by little over time. What you gain is the company's guarantee that the check will arrive on time each month, for the rest of your life. You start "making money" from the annuity if (or when) you outlive the company's assumption about your life expectancy because, as you'd correctly assume, they must keep paying you even if you're over 100! What if you die earlier? Well, the company keeps what's left. That's the tradeoff for guaranteed income.

There are different types of annuities that get incredibly complicated, but all are variations on this same theme. So, if you understand the basic mechanics you can think about your own situation and whether this kind of arrangement sounds appealing.

I have several "rules of thumb" when it comes to annuities, such as a maximum amount of your savings to put into them (no more than 1/3rd, if you do so at all), so let me know if you have any specific questions.

Here's a link to a summary of the YouGov report...

Have questions? Ask me. I can help.

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