Your Personal Finance Glossary, Part 1
April is Financial Literacy Month. It’s okay if you forgot, because I almost did too! The COVID-19 crisis has thrown us all for a loop. But I still want to help you move forward with your financial goals and get your money in order, especially during a global pandemic. That’s why, this month, I’ll be going back to my somewhat normal content, starting with a personal finance glossary.
One of the things that can be most frustrating is seeing lots of terms and words out there that you think might apply to you, but that you don’t actually understand. And it’s okay to not understand - why would you know something if you never learned it? That’s why I’m here! I polled my friends, family, and followers for financial terms that they want to understand better. Here’s what we came up with for this first installment:
Pensions are no longer the norm when it comes to preparing for retirement in the United States. As such, the 401k was created in 1978 to put the onus onto individuals to save for retirement. Your employer provides a 401k for you to contribute to, pre-tax, directly from your paycheck. The money is contributed into your 401k account before you even see it. If you’re lucky, your employer will also contribute a match amount to the account. The amount that you contribute to your 401k is pre-tax, which means that you don’t pay taxes on that money right now. However, you will have to pay taxes on that money when you retire and withdraw the money later in life. The annual contribution limit, in 2020, is $19,500.
The 503b is another retirement account that is basically the same as a 401k. The only difference is that they are for employees of public schools and tax-exempt organizations, rather than private-sector workers. The annual contribution for 503bs is the same as for 401ks.
IRA stands for individual retirement account, which means that it is a retirement account opened by an individual, rather than their employer. If you don’t have a retirement account through your employer, or if you want to save even more for retirement, you can open an IRA for yourself. You can open an IRA at a brokerage of your choosing. The only thing to consider is that many brokerages require a high minimum deposit in order for you to open an account. If you want to open an IRA, but don’t have a large sum, look for a brokerage that doesn’t have a minimum deposit requirement. For a traditional IRA, the tax implications are similar to a 401k. Though you likely can’t contribute to the account pre-tax, the amount that you contribute is tax deductible on your tax return. You will pay taxes on this money when you withdraw it in retirement. The annual contribution limit for IRAs in 2020 is $6,000.
A Roth IRA is the same as a traditional IRA in all ways except for one: taxes. For a Roth, you pay taxes on the money now and you don’t pay taxes on it when you withdraw it in retirement. The way that this works is that you take post-tax money (aka money that is already in your bank account) to fund the account. The annual contribution limit for IRAs in 2020 is $6,000.
SEP stands for Simplified Employee Pension. This type of retirement plan allows small business owners to contribute toward their employees’ retirement as well as their own retirement savings. If you are self-employed, you can open and contribute to your own SEP IRA. Since you are both employer and employee, you can contribute up to 25 percent of your income each year, up to $57,000 in 2020. That’s a whole lot more than a regular IRA, which is why a SEP IRA is such a good vehicle for self employed folks. The tax implications of a SEP IRA are the same as a traditional IRA. The contributions are deductible on your tax return every year. You will pay tax on that money when you withdraw in retirement.
This was actually a term I’d never actually heard before, but it was submitted by a friend of mine. Simply, universal default allows credit card companies to periodically check your credit and increase rates if they deem it appropriate. That means that if there is any change that has negatively impacted your credit score or risk profile, a new, higher interest rate can be applied. That’s some crap, isn’t it? Apparently this is a pretty controversial provision, but it’s completely legal. It has been compared to health insurance companies increasing premiums if an individual smoke cigarettes, even if they haven’t filed an insurance claim. A way for you to avoid this is to try to improve your credit by always making payments on time.
This is a term that you will most likely hear when going through the homebuying process. An “escrow” is an arrangement where a third party holds and manages payment of funds required for two parties involved in a particular transaction. It helps make transactions more secure by keeping the payment in an account and the funds are only released when all of the terms of an agreement are met. For example, if you are buying a home, you will most likely put money for your property taxes into an escrow throughout the year. Then, the taxes will be paid directly from that escrow account, rather than you making the payments yourself. This ensures that the taxes are paid properly.
This term was submitted by my dad. He is curious about capital gains, specifically for homeowners. I had to look into this, since it’s not something I’m not familiar with. A capital gain happens when you sell something for more than you spent to purchase it. This happens a lot with investments, but it also applies to personal property, such as a car. You need to report capital gains on your tax return, which means you’ll have to pay taxes on that money you gained. When it comes to homeowners, though, in most cases, your home is exempt from this. For this to be the case, you must meet these three qualifications:
You owned the home for a total of at least two years in the five-year period before the sale.
You used the home as your primary residence for a total of at least two years in that same five-year period.
You haven’t excluded the gain from another home sale in the two-year period before the sale.
If you meet these conditions, you can exclude up to $250,000 of your gain if you’re single, $500,000 if you’re married filing jointly. This is great news if your home has increased in value and you plan to sell it in the future.
This word is getting thrown around a lot right now, considering the effect COVID-19 is having on the economy. The National Bureau of Economic Research defines a recession as a “significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales”.
A recession is considered aa normal part of the economic cycle. A depression, alternatively, is an extreme fall in economic activity that lasts for years.
Depression is another word that is getting throw around right now. But what is the difference between a recession and a depression? A depression is a severe and prolonged downturn in economic activity. It is commonly defined as an extreme recession that lasts three or more years or leads to a decline in real gross domestic product (GDP) of at least 10 percent. To date, the U.S. economy has experienced many recessions but just one major economic depression: The Great Depression of the 1930s.
Closing costs is a term that you will hear if you are in the process of buying a home. But that doesn’t mean that you know what it means or what is will actually cost you. Basically, closing costs are the fees that you will owe, as a buyer, once you officially close on your new home. They are basically for paying all of the people who have worked so hard to get your home purchased. This usually adds up to 2-5 percent of the cost of the home. According to Zillow, the average buyer pays $3,700 in closing costs. This encompasses things like:
Title attorney fee
Escrow deposit for property taxes and mortgage insurance
And plenty more!
Basically, these costs are unavoidable when you’re buying a home, but it’s easy to forget about. When you are budgeting and planning to buy a home, don’t forget to account for closing costs.
This term came up when I was texting with my sisters and two of my cousins. My one cousin was asking if she should be more aggressive while paying down her student loans and I asked her how much liquid savings she has. She said, “maybe that’s a term you should add to your glossary”, because she wasn’t sure what it meant.
Liquid savings is any money in a savings account that you have immediate access to. Any money in the stock market or even in a CD is not considered liquid. And that is due to a few things:
The stock market is volatile, so your balance is likely to fluctuate over time. That means that you won’t always have the same amount of money available to you.
It can take several days to get money out of your stock market accounts and into your bank account.
If you withdraw money from a CD before the term is over, you will get penalized with fees.
Liquid savings is money that you would keep in a savings account in a bank, preferably one with a high-yield interest rate and no monthly fees. This is the type of account that you should keep your emergency fund in. Any money that you rely on or will need at a moment’s notice should be kept here.
Are there other financial words or terms that you wish you understood better? Send them to me and I’ll include them in my next glossary post! Share in the comments or send me an email at hello (at) maggiegermano (dot) com.