In any case, index funds are terrific. But now we need to look at yet another level of how funds are organized. You could buy an old-fashioned index fund from a great, low-fee company like Vanguard, or you could buy an exchange-traded fund that represents the same exact investment. On average, ETFs will be slightly less costly than old-fashioned index funds, but we’re talking about 1 basis point or 2 lower, a small fraction of 1 percent, and over time, though it might add up, it won’t add up to much. So what exactly sets an ETF apart from a traditional mutual fund, or even another recent development, what are called “closed-end funds”? From the name, you probably understand that ETFs are listed on a stock market; for example, in this country most are on the American Stock Exchange, the AMEX. But that doesn’t get to the heart of the matter.
A regular open-end mutual fund does not trade on the open markets. At the end of every trading day, it uses the closing price of its assets to determine the price of one “share” in the mutual fund. If you want to invest in the fund, you can contribute money at that price, known as the net asset value, and if you want to withdraw money from the account you can go to the fund and ask for your investment back. It’s very simple: you bought a certain number of shares in the fund at some point, and the value of those shares was based on the net asset value of the stocks or whatever your fund owns. When you withdraw your money you pull out the same number of shares, but because the value of the assets in the fund has changed, so will the value of your shares. Open-end funds are constantly creating and retiring shares, but that has no effect on the value of your investment with the fund—it’s not as though these are actual shares of stock or anything remotely like that. Every new piece of money invested in an open-end fund just goes into the same assets everyone else is invested in and doesn’t dilute the yield your mutual fund pays you, or your upside, except in the sense that it’s harder to manage larger amounts of money.
Closed-end funds and ETFs are very different. With a closed-end fund, the guys running the fund will sell huge blocks of its shares as it starts up, use the money to buy whatever assets they intended to buy, and then stop selling shares. The funds rely on the brokers who buy their massive chunks of shares to sell them in the secondary market to regular investors. So shares of a closed-end fund can be traded during the day because they’re listed on an exchange, and these funds are essentially closed to new investment, which in my opinion is terrific for investors because, as I’ve said, running more money will always hurt even a great manager’s performance. Closed-end funds tend to have lower fees too, because the funds don’t have to spend any real time issuing shares or dealing with investors. If everyone wants to bail on a closed-end fund, then the price of the shares will trade at a big discount to the fund’s net asset value. In fact, shares of closed-end funds always trade at a premium or a discount to their net asset value, except when the funds end and cash out of their investments, redistributing the net asset value to their investors. Usually, the shares of these funds will head back toward their net asset value, so you can catch a great opportunity to buy into a closed-end fund at a large discount should the price go significantly lower than the net asset value, which happens frequently.
An ETF is very similar to a closed-end fund, but with one very important difference: ETFs issue new shares and retire old ones priced at the net asset value per share, but only in huge blocks. That guarantee, even if it’s something only big institutional investors can take advantage of, makes a huge difference for the ETF, because it keeps the ETF valued the same way as whatever benchmark it’s following. That’s another point about ETFs: they’re almost always index funds. I know that ETFs are the flavor of the month right now, but as long as you buy an ETF that represents a diversified index (the S&P 500 comes to mind) it’s actually a great deal because the fees are so incredibly low, and because it’s so easy to get in and out of an ETF. Lately, ETFs have become more specialized as they’ve popped up all over the place. My attitude about that is the same as my attitude toward any of the “specialty” mutual funds that focus on only a single sector: there’s no reason for anyone to own these. The banks love to create new ETFs because they’re new products and bring more new fees. Many of them are totally useless to individual investors. Do you really want an ETF that tracks the price of pig bellies? When mutual funds first started to become very popular, all the asset management companies, banks, and brokers started issuing as many mutual funds as they could get away with. The same thing is happening now with ETFs, so what we see are a lot of hyperspecialized funds. There are country-specific ETFs, sector-specific ETFs, and it’s getting even more detailed as you read this.
I think any fund that focuses on something as narrow as a sector or a country is a bad investment. It might do incredibly well one year, but how can you keep up with the homework necessary to understand an entire sector or country of stocks if you have no time to manage your own money? The more sophisticated an old-line mutual fund or ETF, the more specific, the less reason there is for you to own it. People buy funds so that they can stop worrying about diversification, stop worrying day-to-day about the performance of their investments, and generally let an expert make the decisions. That’s not the best way to get rich, but it’s the best way available to most people. If you never buy a fund that’s devoted to a single place or sector and instead buy only diversified funds, you know you’re doing something right.
As for funds that don’t invest in stocks, you could put your money in a money market fund or in a fund that covers any other type of bond. Bond funds are important, and what I would do to build up bond exposure with age is find a bond fund with low fees that invests in U.S. Treasurys. If you’re incredibly rich, put your money into a bond fund that invests in municipal bonds. Your tax savings will still come through even though they briefly pass through the fund, but still look for low fees.
Now what about the different types of stock funds? These all call themselves different names, and the ratings agencies have different classifications for them, so my description of them is just that: a description. An actively managed mutual fund will tend to invest in companies of a given size—so it’s a large-cap fund if it has most of its investments in the stocks of very large companies; a mid-cap fund invests primarily in stocks with a range of market caps in the low billions to the 10 or 20 billions; small-cap funds focus on even smaller stocks. I wouldn’t listen to a word of this garbage. A great fund manager will care only about making money, not whether the stocks going higher fit into the description of the fund. If it’s going higher, then it is a good stock. Any manager who says, “But we invest only in companies of this size” is a fool whom you shouldn’t trust with your money. I have seen all of these fund descriptions violated by different managers over time and there are no mutual fund police to stop managers who do this.
Mutual funds will also get divided up by whether they invest in domestic or foreign stocks and whether they’re “value funds,” “growth funds,” or “aggressive-growth funds.” These too are labels that tell us very little about the quality of the fund, the quality of its manager, the risk the fund actually takes on, or the profits it’s able to generate. I know “value” sounds more conservative than “growth,” but it isn’t. Again, lots of value managers own growth stocks and vice versa. Anyway, it’s all about the fund manager, and unless you’re sure the fund manager is good, don’t try to pick one of the rare mutual funds that beats an index fund. Just get an index, either through a regular mutual fund or an ETF. I know, you want me to tell you who is the best mutual fund manager, and I will do that later in the book, but for now you need to know that the best way to use mutual funds, unless you’re sure your fund has a great manager—and it’s hard to be sure—is simply to invest everything in a low-fee S&P 500 index fund. You won’t want to allocate all of your capital to that fund as you get older, but though it’s not creative, it’s still a great investment that doesn’t take much in the way of homework. If you’re investing in funds, you
don’t want to do homework; that’s why those terrible target-date or life-cycle funds I wrote about in the previous chapter have become so popular, despite being such inexcusably awful funds with exorbitant fees and bad asset allocation.
You need stocks and you need bonds. Never go for individual bonds; always use a fund. I hope you can take advantage of individual stocks because you’ve got the time and think it might be fun—it is—but even if you don’t, you have a lot of options, many of them in the form of index funds, that will still make you money and give you plenty of stock exposure.
5
FAMILY FINANCES
This is not just a book about making money. Growing your capital is only step one. Plenty of people score big and then can’t afford to pay for the truly important things because they never thought about how to preserve their gains. I’ve told you how to fund your retirement, but what about all the other big stuff?
As far as I’m concerned there’s nothing more important than family, and while married couples, especially those with children, are in tax-break heaven, raising a family is an expensive proposition that comes with a lot of other costs. Raising a child and paying for college can easily cost half a million dollars over the first twenty-two years, and that’s if you don’t continue helping out your children with money after they graduate. Good parents don’t need to shower their kids with money, but raising a child will never be cheap, and I think most parents would like to be able to help out if their adult children ever got into financial trouble. But I am not about homilies; I am about money. Teaching your children about money is perhaps the single best thing you can do for them. Paying for the things they need is just as important, which is why I’m trying to make you as much money as possible using any technique that allows you to pay lower taxes and shelter the money for as long as you can, while teaching your kids how to do the same!
And then there’s buying a home. Obviously, home ownership isn’t just for families; it’s practically built into the American dream. Once you start a family, though, owning a home seems a lot more important. Not so long ago, buying a home was considered the perfect can’t-lose investment, the ideal way to build equity. Everyone wanted a piece of the action because the housing market was on fire. Starting no later than 2005, people who never would have been able to get a mortgage because of their credit at any other time began to qualify because the mortgage issuers—typically brokers, who didn’t have to worry about burning their deposit base as a bank would, because they sold the loan immediately—became too confident and lowered their lending standards. It was so easy to make money in real estate. Whenever you heard about “subprime” on TV or in the paper, you were hearing about these people with bad credit buying homes. They typically either didn’t have a lot of money in the bank or had no documents, or, alas, were undocumented themselves! Many of these buyers took out really bizarre, exotic mortgages that had fixed low rates or even no interest for the first two years, and then switched to an adjustable rate for the next twenty-eight years. That didn’t seem like a big deal at the time, when interest rates were really low, but when these mortgages started resetting in 2007, rates were a lot higher, courtesy of the seventeen straight interest rate boosts put through by the Federal Reserve after it encouraged people to take these kinds of mortgages to get a piece of the American dream. The Fed was as irresponsible as the home buyers who took this toxic stuff.
People with a 2–28 mortgage, as they’re called, thought they could just refinance their home with a second mortgage once the first mortgage switched from a fixed rate to an adjustable rate, and, to be fair, they thought that because that is what many of the mortgage brokers and banks were telling them. But higher rates made it impossible for these subprime borrowers to refinance, and the additional charge from the piggybacked home equity loan turned many homeowners into squatters who are just now, as I write, getting evicted. While it looks like some of them may get some help from the federal government, there could be as many as 7 million people who might end up defaulting on their mortgages and losing their homes. Yes, that’s how many home buyers took these risky propositions when they bought their homes between 2005 and 2007.
The sharks who offered these mortgages and the brokers who packaged them and sold them, mainly to hedge funds that wanted to make more money than they could by investing in Treasurys, speak of the 2006 vintage as the worst ever, as if it were just a case of wine. It’s people’s lives, a point I have tried to drive home whenever I speak on this subject. Mostly it has fallen on deaf ears. That is why I never want you to be in that position. In fact, I want to do everything in my power to make sure no one who reads this book ever loses a home. So in this chapter I want to tell you how to pay for kids, how to pay for college, and how to buy a home, mostly by taking advantage of the federal government’s generosity in creating enormous tax breaks for families, homeowners, and people paying college tuition. In fact, I’ll cover a lot of tax breaks that might apply to you, because every extra dollar counts. I’ve never had a moral problem with paying taxes. I know many people, probably many of you, do have strong political objections to taxes, and that’s a legitimate position. I’ve always felt that as a rich guy it would be obscene for me to complain about paying my taxes, or paying for anything else for that matter, even if my tax rate is higher. I have been a huge beneficiary of all the protections and opportunities that this great nation offers. That said, only a real masochist likes paying taxes, and if there are provisions in the tax code that let you pay lower taxes, I think you should go for them.
I’ll start with how you can save money thanks to your children, then how you can pay less for college, and after that how you can benefit from home ownership. I know that for many of you, even most of you, owning a home may be at the top of your list, especially if you don’t have any children and don’t plan on having any, but as a parent I can’t help but give kids top billing here.
Children
The best and easiest way to save on some of the expense of having children is by taking advantage of the child tax credit. A tax credit is subtracted directly from your tax liability, so a $1 tax credit means a $1 reduction in your taxes, regardless of what income tax bracket you happen to inhabit. If you have children and your household income doesn’t exceed $110,000 if you’re married and filing jointly, you can take a $1,000 tax credit per child. That’s $1,000 of taxes you don’t have to pay, practically money in your pocket. Unfortunately, there’s a phaseout if you and your spouse together earn more than $110,000, which means that the credit becomes smaller and smaller as you earn more than that amount, and eventually dwindles down to $0. Then again, you’ll be making a lot more money, so it evens out.
If you have child care expenses, you can get a tax credit or an exclusion. An exclusion is when the government makes a certain amount of your income tax-free, as long as those expenses are incurred in the process of earning an income. So, for example, if you need to pay for child care in order to go to work, that expense qualifies for a credit. Here’s how this one works—and I should mention that this credit is for all dependents, not just children. You can get a tax credit of up to $2,100 a year for these expenses, but that credit gets reduced once your adjusted gross income hits $15,001. Your adjusted gross income isn’t your total income; it’s a tax term that refers to your income after certain deductions. Basically, if you look at your 1040 form, which is what most people use to file their tax returns, your adjusted gross income is reported on the last line of the first page of the form. Even though this tax credit starts to become smaller once you have $15,001 in adjusted gross income, it’s never completely phased out. If the company you work for pays for child care or dependent care expenses, you can take an exclusion of up to $5,000, depending on your income. Again, an exclusion means that as much as $5,000 of your income becomes tax-free.
If you adopted a child and had to pay out-of-pocket expenses relating to the adoption, you can get a really large tax credit. You can claim an adoption credit
of up to $11,390 per eligible child, which is a pretty fantastic credit, but this one also starts to phase out. If you’re married and filing jointly for 2007, this credit starts to phase out if you earn $170,820, and will be totally phased out if your joint income is over $210,820. That’s a pretty high limit, so if you do adopt you can likely take advantage of this credit.
Here’s one that’s not so terrific. Parents who receive child support payments, or the children who receive them, don’t have to pay taxes on those payments. However, the parent who pays child support can’t deduct child support payments from his or her income.
There are some things you can do with income shifting as long as you play by the rules. If you give one of your children investment property, he or she will pay lower taxes as long as he or she is in a lower tax bracket than you are. This doesn’t work too well if your kids are under 18, because then they’ll have to pay a “kiddie tax,” and that eats up most of the tax benefit. You need to be careful about this sort of thing because the more money your child has in his or her name, the less financial aid your kid can get for college.
Jim Cramer's Stay Mad for Life Page 15
