Q&A: What’s the difference between ETFs, mutual funds and index funds?

Dear Liz: What is the difference between ETFs, mutual funds and index funds?

Answer: Index funds are a type of mutual fund. Mutual funds and ETFs both allow you to buy a diversified mix of investments, but they’re structured differently.

Mutual fund shares are usually priced once a day, based on the value of their underlying assets minus liabilities. Investors buy and sell without knowing precisely what the share price will be, since that’s calculated after they place their orders with the mutual fund company. ETFs, or exchange-traded funds, by contrast, trade throughout the day on stock exchanges and can be worth more or less than the underlying investments, depending on demand.

Most mutual funds are actively managed. That means the underlying investments may frequently change as the fund manager tries to “beat the market” and get a better return than a market index or benchmark such as the Standard & Poor’s 500. All that trading increases a fund’s costs and usually doesn’t result in a higher return.

By contrast, index mutual funds just try to match the market benchmark. This is known as passive management. Less trading leads to lower costs and typically better returns.

Most ETFs are passively managed and have even lower costs than typical index mutual funds. ETFs are the investment of choice for robo-advisors, which offer automated investment management, but they also can be an inexpensive way for individuals to invest. Also, ETFs don’t have the investment minimums that can sometimes be a barrier to start investment with mutual funds.

Q&A: Investing a windfall

Dear Liz: My husband and I are retired and recently inherited a large sum of money. We already have money of our own invested and have a good income. Would a whole-life insurance policy based on an index account be a good place to put this money?

Answer: The insurance agent trying to sell you that policy certainly thinks so, because it’s an expensive product that would generate a substantial commission. You’d be smart to get a second opinion from a fee-only financial planner that doesn’t profit from the investments they recommend.

Q&A: Why you might want a Roth IRA

Dear Liz: I never understood Roth IRAs. They don’t offer a tax break for contributions, so they cause you to pay taxes on your money when you’re working and in a higher tax bracket. With a regular IRA, you get a tax break upfront when you’re in the higher tax bracket and then you pay taxes on withdrawals when you’re retired and in a lower tax bracket. What am I missing?

Answer: Not everyone will be in a lower tax bracket in retirement. Some will be in the same bracket or a higher one when it’s time to withdraw the money. People in their 20s, for example, may be in the lowest tax bracket they’ll ever see. People who expect tax rates in general to rise also may wish to hedge their bets by having at least some money in a Roth.

A Roth also can make more sense if you don’t get a tax break for your IRA contributions. That could be the case if you have access to a workplace plan and your income is above certain limits, or if your income is so low that you owe little or no income tax.

Roth IRAs have a few other advantages. Having a pot of tax-free money in retirement can give you some flexibility in managing your tax bill. If a big bill comes up, for example, a withdrawal from your IRA could push you into a higher tax bracket while a withdrawal from your Roth would not.

Roths also don’t require you to take withdrawals in retirement, unlike regular IRAs. You can hang on to the money until you need it, perhaps to pay for late-in-life costs such as long-term care, or you can pass it on to your heirs.

Roths are more flexible in another way: You can always withdraw the amount you contributed to a Roth without tax consequences. Withdrawals from IRAs before retirement typically incur both taxes and penalties.

Q&A: Where to find the most bang for your savings buck. Spoiler: On Wall Street

Dear Liz: I recently sold my home and want to put away funds for my daughters. I want to place $130,000 each in an account that will earn 7% to 10% interest for 30 years or so, providing them with a comfortable retirement fund. I’m thinking of having them start with a low-cost index mutual fund. What are the drawbacks to placing all of the funds in one mutual fund account?

What are the tax implications?

Answer: Stock market index funds mimic a benchmark, such as the Standard & Poor’s 500. That means you’re typically getting at least some diversification, which can help reduce the volatility of your investment.

You could reduce volatility even more by including bond market index funds, or opting for a target date fund that spreads the money across a mix of investments — stocks, bonds, cash. Target date funds are labeled with a specific year in the future and gradually reduce risk as that date approaches. Or you could consider a robo-advisor, which uses computer algorithms and ultra-low-cost exchange-traded funds to create and manage a portfolio.

These investments typically will generate taxable returns, so you’ll want to discuss the implications with a tax pro.

Also, you mentioned earning interest, but interest is what is paid on bonds and savings accounts. Returns are what investors earn on stocks and other higher-risk investments. No investment currently pays 7% to 10% interest. Over time, stocks typically generate average annual returns of 8% or so, but returns aren’t guaranteed and some years your stocks may lose money.

Q&A: Here’s why trying to time the stock market is a really bad idea

Dear Liz: I confess that I am one of those people who panicked and sold a portion of my portfolio in March, against the advice of many who said, “Hold, don’t fold.” Thus, when the market bounced back, I was left standing out in the cold.

I am filled with a tremendous sense of stupidity. I have no idea what I should do with the cash, which remains in a money market account.

Do I wait for a 5% or 10% market correction to reenter the market? Do I leave the money in a money market account, where it earns 0.01% interest, and wait for interest rates to rise?

Answer: You tried to time the market once, with painful results. Why would you want to make the same mistake again?

That’s what you’re doing when you wait for a correction to enter the market. Many people think they’ll have the discipline to do this, but the reality can be quite different.

Once the market drops 5% to 10%, what’s to keep it from dropping further? Would you be able to jump in as others are bailing out? And what if the correction is manageably small but happens after the market has climbed considerably? You would still have missed out on a substantial amount of growth.

You may have panicked because you were taking too much risk with your portfolio. Perhaps you were trying for maximum returns or the proportion devoted to stocks had increased during the previous bull market.

The solution is to craft an asset allocation that reflects your goals and risk tolerance. Then you regularly rebalance back to that asset allocation.

Having such a plan can help you resist the urge to cash out in a downturn. So too can having an advisor who can help you craft a plan and talk you down when anxiety has you climbing the walls.

Q&A: It’s not too late for Mom’s stocks

Dear Liz: My mother is 68. She has had a sizable amount of money in an old work 401(k) for several years now. Unfortunately, it has been stuck in the most conservative low-growth fund for more than 10 years during a time of great stock market growth. If she changed it to a more aggressive fund now, are there tax implications to consider, and would this be an unwise change at her age?

Answer: Ouch. The stock market as measured by the Standard & Poor’s 500 benchmark rose more than 250% in the last decade. Instead of more than tripling her money, her low-growth fund may have barely kept up with inflation.

She can’t get back those lost returns, but she could allocate her money more aggressively without having to worry about triggering taxes. Money in 401(k)s and most other retirement accounts is taxed only when it’s withdrawn.

Q&A: Investing can be scary. How to overcome your anxiety

Dear Liz: I’m 53 and a debt-free homeowner. I’m employed but don’t have a 401(k) and have only about $80,000 in savings. I realize I need to put that money to work somewhere but I just freeze when it comes to trusting myself or someone else to handle it. Markets lately scare me to death, as do fraudulent or self-serving money managers. But as time ticks away, I develop more and more anxiety about it. What would you suggest?

Answer: Many worthwhile endeavors are scary, and you haven’t got a moment to lose.

You don’t have to make yourself an investing expert. You do need to understand enough about how the markets work that you don’t panic at the first downturn and yank your money out. Consider reading a good book about investing, such as “Investing for Dummies” by Eric Tyson, “The Little Book of Common Sense Investing” by John Bogle or “The Broke Millennial Takes On Investing” by Erin Lowry.

While you can’t control the markets, you can control what’s much more important in the long run: how much you invest and how much you pay in fees. Try to maximize the former and minimize the latter. Consider opening an individual retirement account and contributing the maximum $7,000. (The usual limit is $6,000 per year but people 50 and older can contribute an additional $1,000.)

A discount brokerage, such as Vanguard, Fidelity, TD Ameritrade, ETrade or Charles Schwab, will have low-cost target date retirement funds that do the heavy lifting for you, such as choosing investments, rebalancing and getting more conservative as your retirement date approaches.

If you still want help with investing, seek out an advisor willing to be a fiduciary, which means they’re committed to putting your best interests first.

Q&A: Windfall creates Medicare headache

Dear Liz: A couple of years ago, I was forced to receive a windfall by the sale of a company in which I held stock. Besides taking a huge tax hit, I just got my Social Security estimate for 2021 in which my Medicare bill went up by 47%. This year my income will go back down to normal levels. Is there any way to convince Social Security that this was a one-time event and it shouldn’t adjust my Medicare premiums?

Answer: There’s typically a two-year lag between receiving a windfall and potentially having your Medicare premiums raised because of IRMAA (Medicare’s income-related monthly adjustment amount). You can appeal the increase if your income dropped in the meantime because of one of the following life-changing events:

Marriage
Divorce or annulment
Death of a spouse
Work stoppage
Work reduction
Loss of income-producing property (because of a disaster or other event beyond your control, not due to a sale or transfer of the property)
Loss of pension income
Employer settlement payment (due to employer’s bankruptcy or reorganization)
If any of those circumstances apply, you can call Social Security at (800) 772-1213 to arrange an interview. Alternatively, you can download form SSA-44 from the web and mail it in. You will need to provide proof of the event, such as a death certificate, divorce decree or documents from an employer.

Q&A: Roth IRA penalties

Dear Liz: I read your column in which you talked about the Roth IRA and how withdrawals can be penalized if you’re younger than 59½ or the account is not 5 years old. But are there any exceptions? Can we withdraw from our Roth IRA and not pay any tax or penalty if we use the money to pay for our children’s college?

Answer: You can avoid the early withdrawal penalty, but you’ll owe taxes on any earnings you withdraw from a Roth IRA when you use the money for qualified higher education expenses.

To recap, you can always withdraw an amount equal to your total contributions to a Roth IRA without owing any taxes or penalties. You don’t even have to wait five years.

When you withdraw earnings, however, you can avoid taxes and penalties only if the account is at least 5 years old and you’re 59½ or older, or you’re taking the distribution because you’re totally and permanently disabled, you inherited the Roth IRA from the account owner or you’re using as much as $10,000 for a first-time home purchase.

If you don’t meet those qualifications, there are still ways to avoid the penalty if not the taxes.

Withdrawing money to pay qualified education expenses is one of those exceptions, as is paying medical expenses that exceed 7.5% of your adjusted gross income, withdrawing as much as $5,000 after the birth or adoption of a child, paying an IRS levy, taking a qualified reservist distribution if you’re a military reservist called to active duty or taking a series of substantially equal periodic payments.

Let’s say you’ve contributed $20,000 to a Roth that’s now worth $30,000. The first $20,000 you withdraw is tax- and penalty-free. The final $10,000 you withdraw would be taxable, but it would not face the 10% early withdrawal penalty if you used it for your children’s college tuition, fees, books, supplies or other qualified expenses.

Q&A: Volatile markets and retirement

Dear Liz: With the tumult in the stock market, I’ve been thinking of a strategy which may be safe but not prudent. I have about $315,000 in a trust account which pays me about $9,000 a year in dividends. I’m 81. If I sell all the stocks in my trust account, I could draw the same $9,000 for over 10 years, not counting about 2% growth on the $315,000. What are your thoughts?

Answer: Many people have discovered they’re not as risk tolerant as they thought they were. The volatile stock market has unnerved even seasoned retirement investors. Most, however, should continue investing because they won’t need the money for decades, and even retirees typically need the kinds of returns that only stocks can deliver long term.

There’s no reason to take more risk than necessary, however. If all you need from your trust account is $9,000 a year, you’d be unlikely to run out even if your money is sitting in cash. But you may need more than $9,000 in the future — to adjust for inflation, for example, or to cover long-term care costs.

One option to consider is a single-premium immediate annuity. In exchange for a lump sum, you’d get a guaranteed stream of monthly checks for the rest of your life. At your age, you could get $9,000 a year by investing about $100,000 in such an annuity. Because your payments would be guaranteed by the annuity, you might be more comfortable leaving at least some of the rest of your account in stocks for potential growth.