Basic Tax Concepts

The effect of taxation on income and accumulated value is a key investment consideration. Some important terms:

* After-tax/pre-tax investments. Is the income you put into an investment subject to taxation? If so, it is an after-tax investment. Typically, savings accounts and most trading in stocks and bonds involve after-tax income. Pre-tax means that you do not pay taxes on the income you invest—either because the tax is never deducted (such as with contributions to a 401(k) plan) or because you can write your investment off as a tax deduction (like a portion of your contribution to an individual retirement account).
* Capital gains tax. In order to encourage investment, capital gains (profits on securities sold) are taxed at a rate lower than that of regular income, provided you hold the investment for more than 12 months. These are referred to as long-term capital gains. If you hold a security for a year or less, your capital gains are taxed as regular income. Some investments, such as mutual funds, that reinvest dividends may show appreciating values; however, those values are not all capital gains. Reinvested dividends add to the basis of an investment, which needs to be subtracted from the value to accurately calculate capital gains.
* Tax-deferred. This means that the value that builds up in your investment is not subject to taxes until you take it out as income. Most retirement plans and annuities are tax-deferred. Tax-deferred investments usually entail increased taxation as a penalty if you withdraw your funds before a certain date.

Duration, Interest, and Maturity

Investors use duration to predict bond price changes. Duration is a measure of a bond's interest rate risk. Duration is calculated from the weighted average of a bond's coupon rates, principal, and time until these rates are paid. It is expressed as years from a bond's purchase date. As the value of a bond changes, so does its duration. When interest rates change, the price of a bond will change by a corresponding amount related to its duration.

When interest rates change, the price of a bond will change by a corresponding amount related to its duration. For example, if a bond's duration is 5 years and interest rates fall 1 percent, you can expect the bond's prices to rise by approximately 5 percent. Therefore, if you expect interest rates to rise, you want to invest in bonds with lower durations. Low duration means less volatility or price risk.

In general, the shorter a bond's maturity, the less its duration. Bonds with higher yields also have lower durations. A zero coupon bond's duration is the time to its maturity.

What Are Municipal Bonds?

Municipal bonds (nicknamed munis) are bonds issued by states, cities, counties, and various districts.

They are used to raise money to finance operations or to pay for projects. The projects they finance include hospitals, schools, power plants, office buildings, airports, etc. Municipalities levy taxes as their first source of revenue. When they need more money (such as when they overspend), they may turn to issuing bonds as a way to raise extra money. Municipal bonds are used by municipalities to raise money to finance operations or to pay for projects.

Individual investors purchase the majority of municipal bonds. These bonds are usually issued in $5,000 face-value denominations or multiples of $5,000. They mature in anywhere from one to fifty years. Like other bonds, they may also be bought at a discount. For example, an investor may buy a $5,000 bond for only $4,000. At maturity, he or she will receive the original $5,000.

Municipals are considered relatively safe from default despite some adverse notoriety in past years. After they have been issued, they can be sold to other investors on the secondary stock market through exchanges or on the over-the-counter market.

Variable-Rate Certificates of Deposit

Variable-rate CDs are certificates of deposit with rates that move up or down according to changes in interest rates. They were created to keep up with volatile short-term interest rates. Below are some of the most common forms of variable-rate CDs.

Though most CD rates are set by banks, some rise with interest rates. CDs with this feature are called rising-rate CDs.

Stock-index CDs offer rates based on a formula that follows a specified index. For example, the bank may pay a rate calculated at 120 percent of the quarterly average growth rate in the S&P 500 Stock Index.

Two Types of Dividend Reinvestment Plans

There are two types of dividend reinvestment plans:

* Plans that offer shareholders "old stock," or stock that already exists
* Plans that offer shareholders "new stock"

The first type of DRIP has an outside trustee repurchase shares on the secondary stock market. These shares are purchased to re-issue them to shareholders in the dividend reinvestment plan. The shareholder will get the shares at market price. However, the corporation will often offer to cover the commission and fees to encourage shareholders to participate in the plan.

In the second type of DRIP, the shareholders receive newly issued shares directly from the company. This implies that the company has control over whether to provide an additional discount. Some corporations will go as far as offering their stock at 3–5 percent below the market price. Companies offer these discounts because they save the costs of going through an investment banker to issue the new shares. The goal is usually to have shareholders continuing to invest.