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ADV Form (Form ADV): This form is the required application for state registration of an advisor. ADV Part II often serves as the investment advisor disclosure brochure, which includes methods of doing business, fees charged, backgrounds, experience, and types of products and services offered.
Annuity: A contract between an insurance company and an individual, generally providing income to the individual on whose life the contract is based, in return for either a lump sum or a periodic payment to the insurance company. Your assets grow on a tax-deferred basis until they are withdrawn, typically when you retire.
- Fixed annuity: A contract in which the insurance company pays a “fixed” or set amount of income to the annuitant for the term of the contract which can be until the annuitant dies, or for a set period of time. The insurance company guarantees both the earnings and the principal.
- Deferred annuity: An annuity contract that delays (“defers”) payment of income or a lump sum until the investor elects to receive it.
- Immediate annuity: An insurance contract purchased for a single premium (lump sum) that begins to pay the annuitant income immediately following its purchase.
- Variable annuity: An insurance contract with an accumulation period when premiums are paid and invested in a “separate” account for the investor. The performance of the separate account, which is usually invested in the stock market, determines the amount of the payments following the accumulation period. The investor bears the risk for this performance.
Asset Protection: There are legal and financial means to protect your assets from
judgment in the event of a lawsuit. Working with your attorney and your financial advisor, you can build a financial plan that would make you an “ugly defendant,” and less appealing in a potential suit. In most cases, the values of your individual retirement account are asset protected. In Texas (and some other states), the equity in your primary residence (homestead) is asset-protected. College-savings plans called 529 plans are asset-protected in many states. Check with your advisor if this is an important objective for your overall financial plan.
Bank accounts:
- Certificates of Deposit: These are promises from banks to pay you a wage (interest) for a defined period of time. This is a source of funds for banks to loan out money. Banks make money loaning it to people who will pay them interest at a rate higher than is being paid to you, the depositor.
- Checking account: Look for ways to eliminate fees on your checking account. Can you maintain a minimum balance? Look for an account with free printing for your checks. If you use an ATM regularly, are the bank’s locations convenient for your use so you can save on charges that other banks can charge you? Interest on checking accounts is very low and it is taxable as ordinary income. If you have a choice of no-fee checking, this may be preferable to an interest-bearing account.
- Money market (taxable) accounts: Money market funds will be invested in very short-term instruments and usually offers a higher interest rate than your corner bank can offer. There are often higher minimums for opening an account. The Federal Deposit Insurance Corporation does not guarantee the money, and there is a small element of risk as a result. The money is easily accessible if you need it. Interest is taxed as ordinary income, although some money markets are tax-exempt.
- Savings account: Savings accounts in your local bank provide easily accessible funds as a reserve. They can also support your minimum balance requirement to help with your “free” checking. However, this interest is taxable at ordinary income rates and it may be better if you can keep this balance as low as you can for emergency needs.
Beneficiary: This is the party the policy owner designates to receive the benefits to the proceeds of an insurance policy, annuities, or individual or ROTH retirement accounts. It is important to update these beneficiaries when you have life changes, such as a divorce, or when your children reach age 21. If you don’t make the change, you run the risk of your ex-spouse receiving the proceeds. Since minor children cannot be named beneficiaries, you may wish to make changes when they become adults. There have been court cases about the “insurable interest” that a beneficiary may have in your benefits. Special IRS rules apply to retirement plan assets.
Bonds: Bonds are sometimes called “fixed income” instruments. It is the legal obligation of the issuer (government or company) to repay the principal of the loan to bond investors at a specified future date. They are usually issued at “par” or “face” value of $1,000 per bond, which represents the amount of money borrowed by the issuer. For the privilege of borrowing your money (your investment), the issuer pays a “coupon” or a stated interest rate, which is usually on the face of the bond.
- Corporate bonds: These are debt obligations issued by corporations. A corporate bond is a promise to pay interest and redeem the original investment at a pre-set time. Bonds are rated by both Standard & Poor’s and Moody’s. Investment grade bonds are rated at least BBB by S & P or Baa by Moody’s. Bonds with lower ratings are considered to be speculative investments, and traditionally pay higher interest rates due to the higher level of risk involved.
- Government bonds: See corporate bonds. Backed by government entities. Insurance companies wanting to match projected liabilities may use a combination of corporate and government bonds and mortgage loans as underlying investments to back their future promises to pay benefits. Certain government bonds may be exempt from income taxes.
- Municipal bonds: Municipal bonds can receive favorable income tax treatment. The interest is essentially exempt from taxation, but they may be subject to capital gains tax if you buy at a discount (less than face value) and sell later at a premium (greater than face value or purchase price). Investors who purchase municipal bonds issued by the state in which they live may find that the bonds are exempt from both state and federal tax. If you live in a state with an income tax, you may find this to be a helpful tax strategy. Municipal bonds may be purchased individually or as part of a bond mutual fund. Here’s a little-known fact: The income from municipal bonds is counted against your exemption on taxing Social Security benefits.
- Savings bonds: U.S. savings bonds can be a way for younger employees to develop the saving habit. The interest is taxable when you redeem them unless you use them toward expense for higher education (with some phase-outs for higher gross income levels). As you progress into higher tax brackets, these may not be the best savings vehicles for you.
- Zero-coupon bonds: This type of bond is traded at a deep discount to its face (par) value. The bond pays no interest (zero-coupon) but is set to be redeemed at face value when it matures at a future date. The most familiar of this type of bond is the U.S. Savings bond where you pay less today for a larger future amount.
Broker/Dealer: A firm in the business of buying and selling securities. A firm may act as both a broker (agent) and as a dealer (principal) but not in the same transaction. A broker-dealer provides compliance oversight for its registered representatives.
Cash Value: This is a value in permanent life insurance policies that represents the cumulative value of your premium payments and the credited earnings of the account reduced by any sales fees, state premium taxes, costs of insurance (mortality expense) and other administrative expenses.
Clearinghouse: An intermediary between the buy and sell sides in a securities transaction that receives and delivers payments and securities. May also have “custody” of client assets.
Cost basis: The price paid for an asset, including any commissions and fees that is used to calculate gains and losses at the time the asset is sold. When you receive an asset as a gift, the cost basis is the donor’s cost (under current IRS rules). When you receive an asset as an inheritance. You may take a “step-up” in basis as the fair market value as of the date of death or the date six months later, if elected. Consult your tax advisor regarding this provision.
Dividends received from participating life insurance policies are considered a return of principal and are not taxable until your total cost basis in the policy has been recovered.
Insurance:
- Auto insurance: You can often save on your premium by increasing the deductible. If your daily miles to work are reduced by a change in employment, be sure to contact your insurance carrier for a potential reduction. Taking a defensive driving class can also provide discounts with some carriers in many states. If you are driving an older car, you may consider increasing the deductible for collision if the exterior appearance is not important to you. That will also save you on your premium. Confirm with your insurance company what would be paid to you if your car were to be totaled in an accident. What you are paying for collision is what you would receive if the car were declared a total loss. Should you feel comfortable with absorbing this potential loss, you could self insure and drop the collision coverage. If not, just raise the deductible. A properly licensed property and casualty agent can advise you of alternatives.
- Homeowner’s insurance: Look at your deductible. If your budget can manage a repair under $1,000, raise your deductible and save on premiums. Check with your insurance agent for premium saving on higher deductibles. Check the maps for your area to see if flood insurance is recommended. Once it starts raining, it’s too late to apply for coverage. At higher income levels, consider a deductible of 1 or 2% of the home value. When you consider the amount of coverage needed, remember that you don’t really need to insure the land. Just think about what it would cost to rebuild, repair, or replace the contents.
- Disability: Disability insurance can provide income in the event that you are temporarily or permanently disabled or have an illness that results in a prolonged absence from work. In cases where there is only one breadwinner, disability insurance can provide comfort and reassurance for the stay-at-home spouse, who may not be able to re-enter the work force quickly or at a comparable level. Having personal guaranteed renewable non-cancelable disability coverage adds another layer of security and protects your income stream. There are many variables such as whether you can return to work in your previous (“your own”) occupation vs. “any” occupation, or how long the waiting period is before benefits begin, that can affect your costs. If you are in a high-risk occupation (greater chance of being hurt), it may be a challenge to build adequate coverage.
Life insurance:
- Term insurance is often perceived as the least expensive because the rates are “cheaper” particularly when you are younger and healthier. As the insured ages, the rates go up. Often the policy becomes too expensive to maintain in later years due to age and health considerations, and the policies lapse when they are most likely to be utilized. Term insurance is more like “renting” insurance and does not include any cash build up inside the policy.
- Permanent life insurance: Universal life and whole life insurance policies are two types of permanent life insurance. They spread the cost of insurance over the life of the insured. For this reason, their perceived cost is higher in the early years because the risk of mortality (dying) is low and the insured persons are usually in good health. Some of the premium is used to build up cash in the policy for use later—to offset the higher cost of insurance—and can be used by the insured by way of policy loans. Universal life offers a flexible premium after the first few years of the policy are paid. Within limits, you can decide how much to pay to keep the universal life policy in force for your loved ones.
- Variable universal life: You will read about variable universal life, which invests in the stock market. In the 1990’s, when the stock market was soaring, people liked these policies because the value continued to rise. When the stock market declines or is volatile, the underlying value of the policy may disappear and you may have to pay additional premiums to keep the policies in force. We do not recommend this type of policy for most people, as our goal is protection and the reduction of risk for you and your family.
- Survivorship Life insurance: Also called “second-to-die” policy. This type of insurance covers two lives under one policy and pays the benefit after the death of the last surviving insured. It can be a tool used in estate planning and in asset protection.
Consumer debt: Consumer debt is the term for non-deductible loans or accounts where you make regular payments and are charged interest for the privilege of the extended payment terms. Examples are furniture store payments plans, credit cards, automobile loans or student loans. Use credit as a tool to help you establish and maintain credit for larger purchases and emergencies. Don’t let it become a trap as you “borrow” to maintain a lifestyle beyond your means. Student loans may have some interest deductions allowed. Check with your tax advisor to see if you qualify.
401(K) The account provides a tax deferral as you make your contribution and reduces your gross pay today but the earnings on the account are taxable upon withdrawal, often when you are in the highest tax bracket of your life. For some people, this is a way to save for the future in a disciplined way because they do not receive the money in their paycheck. We recommend that you diversify your investment choices since you already have your job security dependent on the stability or growth of the company where you work.
Company match/supplement: Refer to 401 (K) above. This is not “free” money as is commonly perceived. IRS rules mandate certain funding levels depending upon the concentration of wealth for highly compensated executives.
Managed Accounts: A portfolio of investments in which the investor has direct ownership of the securities (stocks or bonds). A professional money manager actively manages the account and makes decisions about which securities to buy and sell. The account is designed to meet the individual investor’s objectives. Sell decisions can be coordinated to minimize income tax liabilities. Investors can also exclude certain stocks or bonds from companies in which they hold positions in other accounts such as employee stock plans.
Modified Endowment Contract (MEC): A life insurance policy under which the amount of premium paid in by the policy owner in the first years of the contract exceeds the sum of net level premium that would have been payable to provide paid-up future benefits in seven years (7-pay test). Under current IRS rules, a MEC no longer qualifies as a life insurance contract for the tax deferral benefits on earnings and proceeds.
Mutual Funds: An investment company that offers new shares on a continuous basis. A mutual fund is an actively managed set of securities, which is invested according to a set investment objective as stated in the prospectus. Shares are redeemable on a daily basis at net asset value but are not traded on the secondary market throughout the day.
A/B/C Class Shares: Most mutual fund companies offer several “classes” of shares. For full information about a specific mutual fund, consult the prospectus. In general, “A” shares assess a sales charge up front, at the time of purchase and management and operations fees on an ongoing basis. Most Class A shares offer discounts on large purchases. They are usually most advantageous for investors who plan to be invested for a long time horizon and who wish to pay the bulk of their fees up-front.
“B” shares are generally structured such that no commission is charged to the investor at the time of the purchase and the fund sponsor compensates the representative. Since no commission dollars are removed at the time of investment, all dollars of your investment are immediately invested. Class B shares usually charge higher ongoing marketing fees than those of equivalent a shares. Most Class B shares carry a Contingent Deferred Sales Charge (CDSC). This is a charge that is applied to withdrawals of principal invested during the first years after the date of investment. In other words, there is a charge to take out your funds. Class B shares are most advantageous for investors who intend to remain invested during the CDSC period, do not wish to pay an up-front sales charge and who do not have sufficient investment dollars to reach a significantly reduced sales charge versus the equivalent Class A shares.
Class C shares are similar to Class B shares in that no commission is charged to the client at the time of the purchase and the sales representative is compensated directly from the fund sponsor. The representative’s initial compensation is typically much lower than the initial compensation on Class B shares. Class C shares typically assess annual marketing fees as high as or slightly higher than the equivalent Class B shares. They usually have a very short Contingent Deferred Sales Charge (CDSC) period. Class C shares are most advantageous for investors who may not remain invested for a long period and who do not have sufficient investment dollars to reach a significantly reduced sales charge versus the Class A equivalent shares. They are especially advantageous for investors who want to pay fees for only the years they are invested, avoiding the long CDSC period of Class B shares and the higher up-front charges of Class A shares.
Ownership: This issue is particularly important in second (or third) marriages. Property brought into the marriage should be clearly identified. In Texas, and other states influenced by Spanish culture, Tenants in Common accounts (each party owning a percentage) offers tax advantages over Joint Tenants with Rights of Survivorship.
Paid-up additions: Money paid in addition to the base premium can be used to buy “paid-up” insurance on a net single premium basis at the insured’s attained age at the time the additions are purchased. Depending on the type of permanent policy, this can buy additional death benefit and/or add to the accumulated cash value.
Paid-up insurance policy: A paid up policy is a contract on which no further premiums are due and for which the insurance company is obligated to the benefits as issued. You sometimes hear “paid up at 65” or “paid up at 95” which means that you will pay premiums through age 65 (or 95) and no further premiums will be required, but you will still have the insurance coverage in place. With some permanent life insurance policies (and it varies by company), if you decide at a certain point that you would like to discontinue paying premiums, you can request that your policy be converted to “paid up” status and they will inform you in writing of the available face value and net cash value at the time the policy becomes “paid up.” To be able to do this, the accumulation of the cash value and dividends must be greater than the net single premium for the insured at the age of the request.
Private placement (outside business interests): These are investments in private entities. If your son invites you to invest in his lawn mowing business, are you likely to get back the cost of his mower? Probably not. The same concept applies to larger private placements. The potential return may be greater, but the potential for loss of your investment may also be high. Regulations often impact who is a “qualified” or “accredited” investor, based on your annual income and net worth.
Prospectus: A legal document that provides details of your potential investment. Regulations spell out what must be included. The goal is to provide you with full information for you to make your investment decision before you invest.
Social Security: While the future stability of Social Security is uncertain, you should be conservative and not rely on Social Security for your retirement years. If it is there, that will be a bonus for you. The U.S. Congress must address the impact of an aging population and fewer wage earners contributing to the trust fund. Today, the Social Security system is simply a transfer of wealth from today’s workers to today’s benefit recipients, using the government as a transfer agent.
Stock: Also called equity securities. Stock represents a position of equity ownership in the issuing corporation.
- Common stock: Owners of common stock (share holders) can vote on the board of directors of the corporation and on major corporate policy issues when they receive their annual “proxy” ballot before the annual shareholder’s meeting.
- Preferred stock: An equity security that represents ownership in a corporation with a stated dividend, which must be paid before dividends are paid to common stock holders. It usually does not offer any voting rights.
- High-dividend stock: These stocks pay dividends that are higher than the market average. Sometimes these are firms with low growth potential or poor performance who need to attract investors by offering a higher dividend. Examples might be tobacco companies or highly regulated firms such as electric utilities. As a result of the EGTRRA of 2003, qualifying stock dividends are taxed at the lower capital gains rate rather than as ordinary income. Currently, reinvesting your dividends (towards the purchase of more stock) compounds your taxes. A tax-efficient strategy would be to purchase high dividend stocks in a deferred account such as an IRA. Historically, high dividend yields may provide some assurance of returns in a down market. When a company reduces its dividend, it is usually a sign of financial trouble.
- Low-dividend stock: These are stocks that pay dividends that are lower than the market average.
- No-dividend stock: Companies that do not offer a dividend are reinvesting their earnings into building the company. This is common with start-ups and technology companies. Hopefully, these stocks may provide appreciation in value. If held more than one year, the gains will be taxed at the lower capital gains tax rate when held in taxable accounts.
Tax-deferred: Financial instruments where taxes may be paid at a later date. Deferred annuities are examples of tax-deferred investments. Cash values in a permanent life insurance policy would fall into this category.
Tax-exempt Money Market: Consider this if you need tax-efficient investment strategies. The money in this account will be easily accessible if you need it.
Umbrella liability insurance: An umbrella liability policy can protect your family in today’s litigious society. If your cleaning lady falls on the front sidewalk, would you be covered if she sued for injury or damages? These policies are usually fairly inexpensive unless you have expensive “toys.”
No specific investment is implied. SMART Group Houston does not provide tax or legal advice.
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