5 Financial Topics Everyone Needs to Know
Understanding finances is not everyone’s cup of tea. Often in a relationship, one spouse handles and understands the finances, while the other remains unaware or uninterested. If you are that person, here is a list of 5 basic topics we believe are helpful for you or anyone else not normally interested in finance to know.
Difference between Roth IRA and Traditional IRA
What are the differences?
IRAs are tax-advantaged accounts designed for long-term savings and investment. The two most common IRAs are the Roth IRA and the Traditional IRA. It is important to note that these accounts can hold the same investments and have many similarities, but the main difference arises when dealing with taxes and whether you owe the IRS money now, or later. The key difference between Roth and Traditional IRAs is in the timing of their tax advantages: With Traditional IRAs, you deduct contributions (lower your taxes) now but pay taxes on withdrawals later; with Roth IRAs, you pay taxes on contributions now but get tax-free withdrawals later. Some of the other differences include the income-eligibility restrictions, distribution rules, and pre-retirement withdrawal rules.
Which one is better?
Unfortunately the answer is “it depends.” The key consideration when deciding between Roth IRA and Traditional IRA is how you think about your future income and taxes. If you expect to be in a higher tax bracket when you retire, a Roth IRA might be the better option because you will pay taxes now, rather than later. On the contrary, if you expect to be in a lower tax bracket in retirement, then a Traditional IRA may make the most financial sense.
Benefit of compounding interest
Compound interest occurs when the interest you earn on a balance in a savings or investing account is reinvested, earning you even more interest. Compound interest is essentially “interest on interest”, which will make an amount of money grow substantially quicker than simple interest which is interest only on the initial amount deposited. This is an important concept to understand when it comes to investing; the earlier you can save money through investing, the more years it allows interest to compound. This concept can be illustrated by an example: if you have $100 and it earns 5% interest each year, you'll have $105 at the end of the first year. At the end of the second year, you'll have $110.25. Not only did you earn $5 on the initial $100 deposit, you also earned $0.25 on the $5 in interest. Although 25 cents may seem like a small amount, it will eventually grow to thousands of dollars. Understanding this will hopefully encourage you and your family to begin investing and saving money early on in life.
Complexity between risk and return
Generally, the higher the potential return of an investment, the greater the risk involved. Some investments are riskier than others meaning there’s a higher chance that you could lose some of your money, but also a higher potential return.
Stocks have a potentially higher return than most bonds over the long term, but they are also riskier. Stocks represent partial ownership, or equity, in a company. When you buy stock, you’re actually purchasing a tiny slice of the company — one or more "shares." When the company you invest in is successful, the value of the company should increase along with the value of your investment. Then, when you decide to sell the shares you own, you may see a profit. The contrary is also true that if the company underperforms, you have the potential to lose money which creates the risk involved with investing in stocks.
Bonds are a loan from you to a company or government. A company is essentially in debt to you when you buy a bond, and it will pay you interest on the loan for a set period, then it will pay back the full amount you bought the bond for at maturity. Although generally less volatile, bonds aren’t completely risk-free. If the company is unsuccessful and goes bankrupt, you’ll likely stop receiving interest payments and may not get back your full principal.
Social Security basics
Who receives Social Security?
Today, ⅓ of retirees rely on it for 90% of their income. For the majority of retirees, it accounts for at least half of their retirement income. More than 62 million people currently receive Social Security benefits.
Who funds Social Security?
Social security is funded through the taxes that US workers pay into the system. These taxes go to retirees who currently receive benefits.
How do I get my Social Security money?
As you work and pay taxes, you are building “credits” in the program. Each credit is worth an amount of earnings that changes year to year. Once you reach 40 credits (40 quarters or 10 years), you become eligible to receive your benefits.
Once you reach full retirement age, you are eligible to receive your full retirement benefit from Social Security. Full retirement age is between 66 and 67 depending on when you were born. You can take benefits as early as age 62, but taking benefits before full retirement age will lower your benefits. Conversely you can wait until age 70, and receive a higher benefit.
Term life insurance vs. Permanent life insurance
Term life insurance
Term life insurance is a policy that provides coverage for a specific term or period of time, typically between 10 and 30 years.This is designed to give your beneficiaries a payout if you pass away during the set term. Because this form of life insurance does not have any cash value attached to it, it is considered “pure” insurance. This form of insurance is usually best for around 90% of people and comes with the lowest cost.
Permanent life insurance (Whole or Universal life insurance)
Permanent life insurance provides coverage that lasts your entire life as long as premiums are paid. Unlike term life insurance, it normally includes a cash value component in addition to the traditional death benefit. These policies are typically significantly more expensive than term insurance, and work best for people doing estate or business planning.
Our hope is this blog helped you understand more about some financial concepts that are talked about often in the “financial world”. As you begin to think about these more, we also encourage you to have conversations with your spouse, as well as your children about other topics. It is important for both spouses to have a budget, understand what is going on inside of the budget, and help your kids begin to budget. Along with that, be sure that you discuss your estate plan with your spouse to ensure that you have all documents in place and that all of them are up to date.
As a financial planning firm, we are here to educate you and help you further grasp these concepts, no matter your level of current understanding. If you have any questions, please reach out to us!