Here at LIS, we have the goal of helping clients better understand and navigate the complexities of their assets. Unfortunately, embarking on a financial planning journey can feel overwhelming. You’re faced with an alphabet soup of acronyms and terms like “capital gains,” “asset allocation,” and “fiduciary.” It’s enough to make anyone want to give up before they even start. But don’t let the jargon create unnecessary anxiety and prevent you from engaging with your financial future!
The truth is, financial planning concepts aren’t as complex as they seem. Behind the scary words are simple concepts that you likely already know intuitively. When you break down these big words into plain language, you’ll feel more confident and empowered to take control of your financial future.
Here’s a breakdown of some commonly misunderstood financial planning terms, to help remove some of the fear that often comes along with them:
Diversification
The scary part: “Diversification” sounds like a complicated investment strategy for high-level financiers. In reality, it’s a foundational concept for anyone building wealth.
The simple breakdown: Diversification is a strategy to manage risk by spreading your money across a variety of investments. It’s the financial equivalent of the old saying, “Don’t put all your eggs in one basket”. The goal is to reduce the impact of a single underperforming investment on your overall portfolio.
In a practical sense:
Instead of putting all your money into one stock, you spread your investments across a mix of asset classes so that if one area of the market performs poorly, your entire portfolio isn’t brought down with it. An example such a mix would include the following:
- Different types of stocks (large companies, small companies, growth and value companies)
- Bonds (government and corporate debt, short-term and long-term)
- Protected/insured assets (annuities, CDs, pensions)
- Cash and cash equivalents
- Real estate
Fiduciary
The scary part: This term is often heard in the context of financial advice but can be vague. What does it actually mean for you?
The simple breakdown: A fiduciary is a person or organization that acts on behalf of another person, and this is a legal and ethical obligation to put the client’s best interests first. Mick & Tyler are both CERTIFIED FINANCIAL PLANNER™ professionals, and as such, they must act in a fiduciary capacity, so you can be confident that the advice you’re getting is unbiased and in your best interest.
In a practical sense: A fiduciary relationship matters most when there is a conflict of interest. An example is when a financial advisor could sell you one of their company’s products that earns them a high commission, or an equivalent product from another company that is a better fit for you but earns them a lower commission. A fiduciary must choose the option that is better for you, regardless of how it affects their own compensation.
Required Minimum Distributions (RMDs)
The scary part: “Required Minimum Distribution” sounds like an intimidating and confusing rule enforced by the IRS. In reality, it’s a way for the government to collect the taxes you’ve deferred for years on your retirement savings.
The simple breakdown: RMDs are the annual minimum amount you must withdraw from your tax-advantaged retirement accounts, like traditional IRAs and 401(k)s, once you reach age 73. You can always withdraw more than the minimum amount if you wish.
In a practical sense:
- The Age: The age for beginning RMDs was increased to 73. For many years it was 70.5, then it moved to 72, and is currently 73.
- The “Why”: The IRS deferred taxing your retirement contributions and growth for years, and now they want their cut.
- The Accounts: RMDs apply to tax-deferred retirement plans, including traditional IRAs, SEP IRAs, SIMPLE IRAs, 401(k)s, and 403(b)s. Roth IRAs, however, are exempt from RMDs!
- The Calculation: The amount is calculated each year by taking your account balance from the end of the previous year and dividing it by a life expectancy factor provided by the IRS.
- The Penalty: Missing an RMD deadline can lead to a significant 25% tax penalty on the amount you failed to withdraw. However, this penalty can be reduced to 10% if corrected in a timely manner.
- First-Year Grace: You can delay your first RMD until April 1st of the year after you turn 73. However, if you wait, you will have to take two RMDs in that year, which could increase your tax liability.
Asset Allocation
The scary part: “Asset allocation” sounds like a high-level technical term, but it’s simply the blueprint for how you structure your investments.
The simple breakdown: This is the process of deciding how to divide your investment portfolio among different asset categories—like stocks, bonds, and cash—to optimize your risk and reward. Your ideal asset allocation will change over time based on your financial goals, time horizon, and risk tolerance.
In a practical sense:
- A 30-year-old saving for retirement might have a more aggressive allocation, perhaps 80% stocks and 20% bonds, since they have a long time to recover from market volatility.
- A 60-year-old approaching retirement might shift toward a more conservative allocation, like 40% stocks and 60% bonds, to protect their principal.
Capital Gains
The scary part: “Capital gains” is a term often associated with complicated spreadsheets and the fine print on a tax return. In reality, it’s just the government’s way of taxing profits on your investments.
The simple breakdown: A capital gain is the profit you make when you sell an asset for more than you paid for it. The Internal Revenue Service (IRS) considers almost anything you own for personal use or investment—stocks, bonds, real estate, and even collectibles—to be a “capital asset”. The profit is the difference between the selling price and your original purchase price (known as your “cost basis”).
In a practical sense:
- It matters how long you’ve held the asset:
- Short-term capital gains: If you sell an asset you’ve owned for one year or less, the profit is treated as regular income and taxed at your ordinary income tax rate. This is the highest tax rate on capital gains.
- Long-term capital gains: If you hold onto the asset for more than a year before selling, the profit is taxed at a lower, more favorable long-term capital gains rate. This is designed to encourage long-term investing.
Here’s an example:
- You buy 100 shares of a stock for $5,000.
- If you sell it for $7,000 after 6 months, you have a $2,000 short-term capital gain, taxed at your higher ordinary income rate.
- If you sell it for $7,000 after 2 years, you have a $2,000 long-term capital gain, taxed at the lower long-term rate.
Financial planning shouldn’t be intimidating. By understanding these key terms, you can feel more confident and empowered when discussing your financial future. The financial professionals at LIS stand ready to help you cut through the noise and build a clear, actionable plan, as well as to help educate you so that you can move forward with confidence as you make decisions for your financial future.