Getting into personal finances is a lot like learning a new language. There are some crazy-sounding words that can be a little intimidating at first. But once you get the lingo, you’ll have a new skill that allows you to communicate more clearly with bankers, accountants, financial planners, investment advisers, brokers, real estate professionals, benefit administrators, and might even make you more interesting at an upcoming holiday party!
Understanding a few key technical terms can boost your confidence and make you feel more comfortable about seeking help from a financial pro.
8 Common Financial Terms to Know:
1. Pre-tax: This is a term that’s commonly used when you’re talking about retirement accounts, like a workplace 401(k) or an IRA (Individual Retirement Arrangement). Pre-tax money means that no taxes are deducted. You invest pre-tax money in “traditional” retirement accounts and pay tax later when you withdraw funds. Traditional retirement accounts are called tax-deferred investment vehicles because they allow you to temporarily avoid paying tax.
2. After-tax: You invest after-tax or taxed money in “Roth” retirement accounts, like a Roth IRA or Roth 401(k). The fantastic benefit of a Roth is that you pay taxes once and never again because it’s a tax-free investment vehicle. Even if the account mushrooms in value, neither your original contributions nor the growth in the account is taxed when you withdraw funds. In contrast, you pay tax on both your initial contributions and their earnings when you withdraw money from a traditional retirement account.
3. Capital gain: This term refers to the profit you make when you sell an investment, such as real estate, stocks, bonds, mutual funds, or exchange-traded funds (ETFs). The difference between the basis (see below) and the selling price can be either a capital gain or a capital loss. Capital gains are classified as either short-term or long-term. You pay short-term capital gains tax if you owned the asset for a year or less and long-term capital gains tax if you owned it for more than a year at the time of the sale. Everyone wants long-term capital gains because the tax rate is much lower than ordinary income tax. Short-term capital gains tax is the same as the ordinary income tax rate.
4. Ordinary Income: This term refers to the money you make that’s subject to ordinary or regular income tax, such as salaries, wages, tips, commissions, bonuses, interest, dividends, and traditional retirement account withdrawals. There are six tax brackets that range from 10% to 35% depending on the total amount of taxable income you have for the year.
5. Basis: This is the amount used for figuring any gain or loss when property—like real estate, stocks, mutual funds, or exchange-traded funds (ETFs)—is sold. Your basis is your original cost plus or minus any adjustments. Although redundant, this is sometimes referred to as your adjusted basis.
6. Tax deduction: This is an amount that the IRS allows you to subtract from your taxable income. A few examples of deductions are charitable donations, student loan interest, mortgage interest, and traditional IRA contributions. Everyone wants to reduce their taxable income because that reduces the amount of tax you have to pay. For instance, if your taxable income is $40,000 and you can claim $10,000 in allowable tax deductions, then you only have to pay tax on $30,000. A tax deduction reduces the income on which your tax is calculated.
7. Tax credit: This is an amount that the IRS allows you to subtract from the actual amount of tax you owe. That makes tax credits more valuable than tax deductions in most cases. An example of a common tax credit is the Child Tax Credit which can be as much as $1,000 per eligible dependent child that you have under the age of 17. The Retirement Savings Contribution Credit helps low and moderate-income taxpayers who make contributions to an IRA or workplace retirement plan.
8. Rollover: This term might sound like a silly dog trick, but there’s nothing funny about it! A rollover allows you to avoid taxes when you withdraw funds from a retirement account. The catch is that you have to redeposit the funds into a new retirement account within 60 days. For example, if you have a 401(k) at work and decide to leave your employer, you can rollover the money into an IRA or a new company’s retirement plan. But if you miss the 60-day deadline the withdrawal becomes taxable plus you’ll have to pay a steep 10% early withdrawal penalty if you’re younger than age 59½.
This is a great primer–but to really learn the language, make a resolution to read a personal finance book every month in 2011. Pick up a copy of my new book, Money Girl’s Smart Moves to Grow Rich, at your favorite book seller. You’ll learn everything you need to know about money without getting bogged down with what you don’t. It covers how to create a financial plan, choose the best banking accounts, deal with debt, save for retirement, invest to create wealth, buy real estate, pay for education, save money on taxes, and lots more. Continuing your financial education will give you the power to make smart money moves and build serious wealth for your future.