Four More Terms

Hopefully you’ve been finding these weekly posts about financial terms to be helpful and informative. We’ve typically been reviewing two terms per week, but let’s switch it up a bit this time and look at shorter definitions of four: dividends, garnishment, FICO score and IRAs.

Dividends – Dividends are what companies pay to investors who own shares of company stock. These payments typically occur quarterly and, over time, make a big difference in an investor’s total return. How much of a difference? Going back many decades, reinvesting dividends has contributed about 40% of the S&P 500’s (the typical stock benchmark) historical average annual return of almost 10%.

But not all companies pay dividends. Apple Inc, Berkshire Hathaway, Amazon and Google are some of the largest companies in the index and don’t pay a regular dividend. Partly due to this, the index currently averages about 2% versus a historical average of about 4%.

Most folks receive their dividends from the mutual funds they own. These funds hold the stocks, receive the dividends and then pass them through to fund shareholders, usually every quarter.

While dividends help boost your return, they are taxable in the year received unless, of course, they’re owned in a retirement account, but we’ll get to that later.

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Garnishment – If you owe someone money, say following a court case with a judgment against you, the person can take money right from your paycheck if doing so has been ordered by the court system. This can also happen if you default on student loans, don’t pay your taxes, or flake on child support payments.

There are limits to how much of one’s paycheck can be garnished, however. Typically, the limit is no more than 25% of your pay after deductions for income taxes and payroll taxes. Also, a more complicated formula exists to, essentially, take as much as possible while still allowing the debtor to cover basic living expenses. Deeper garnishments, even up to 60%, can be taken for missed child support payments.

Once the process has started, the only ways to stop a garnishment are to pay the debt in full, appeal to the court system, or perhaps declare bankruptcy. I hope this never applies to you but, if it should at some point, make sure to have a meaningful conversation with a good lawyer.

FICO score – Fair Isaac Corp is a publicly traded company (FICO is its ticker symbol) based in San Rafael and is probably the biggest brand name in consumer credit scoring. According to the company their scoring is used in 90% of lending decisions in the U.S. each year. Your FICO score is incredibly important if you want to borrow money or even do something mundane like buy car insurance.

Good scores are perhaps 670 or higher. Excellent scores range from the high 700’s and top out at 850. Scores go all the way down to 300, but 580 to 669 is considered the “subprime” range where borrowers have to pay higher interest. Lower than that and you’re going to have a tough time borrowing at all.

The five categories impacting your score are (in order of priority) payment history, amounts owed, length of credit history, types of credit, and recent credit. This all makes sense if you think about it like a lender; you’ll feel most comfortable lending to someone who can show they don’t need to borrow.

IRAs – Individual Retirement Accounts sprang into life back in 1974 and since then savers have used them to… you guessed it, save for retirement. The short-hand definition for these accounts is that you’re saving while making a tradeoff with the government. They will give you tax breaks to save, but you’ll have to pay income tax on all future distributions. In general, the longer you save with this kind of account the better you’ll make out in the end.

The reason has to do with the two main tax breaks you’re getting from the government. If you earn a modest income, you’ll be able to save $6,000 ($7,000 if you’re 50 or older) this year and get a tax deduction for doing so. That’s tax break #1. Tax break #2 is you won’t have to pay taxes each year on dividends or capital gains in the account; it’s all off the radar until you start distributing money down the road.

But that’s when the tradeoff is realized. If you need to withdraw money before age 59.5, you’ll have to pay taxes and a 10% penalty. After that, no penalty but yes to taxes. And if you don’t “need” the money but are older, say 70.5+, the government makes you take a relatively small distribution each year so they can tax you on it. While this can seem obnoxious, remember what you’ve received: tax-deferred growth on every dollar saved, potentially for decades. The government has to “get theirs” eventually, right?

Here’s a link to a summary of the YouGov poll:

https://today.yougov.com/topics/finance/articles-reports/2018/02/27/americans-confident-financial-terms-mean

Have questions? Ask me. I can help.

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