Cocktail Investing. Hawkins Lenore Elle

and so on.

      When Sophia started to get that glazed look that often comes from such a riveting conversation, we told her to think of it this way. You know how the furniture you buy from Ikea comes in those little boxes that look so harmless up until you start trying to put it all together? Some people are really comfortable with a hex key and wooden dowels; they'll put together an entertainment center from Ikea without even looking at the instructions. Others prefer to follow the instructions step-by-step and may even look for tips and tricks on Google. Some prefer to just hire someone to put the whole thing together.

      She told us that she thought she was more the instructions type, but was curious as to how the others work as well.

      So we told her that before we even talk about opening up a brokerage account, she first needed find out if her employer offered a 401(k) plan, and if so, did the company do any sort of matching contributions? Money that goes into a 401(k) reduces taxable income, thus reducing the amount of your income that you lose to the government, and your 401(k) savings can grow without having to pay any taxes on investment gains or income until you start taking money out of it. This helps to grow your savings a lot faster. We'll show you how.

      Since Sophia was self-employed, she wouldn't be able to take advantage of an employer 401(k) plan, but she was going to contribute to an IRA she planned to set up. When possible, maximize your allowable contribution to an IRA. Depending on your income and tax-filing status, you may be able to use some or all of your contribution as a tax deduction. Either way, the money within your IRA grows, like a 401(k), without having to pay any sort of taxes. Again, taxes are only paid on it when you take the money out.

Figure 2.1 shows the difference between growing your savings inside of a nontaxable IRA or 401(k) versus in a taxable account.

Figure 2.1 Investment growth in taxable versus pretax accounts

      If we look at a three-year period, and for the sake of simplicity assume you get 8 percent returns every year, and that were the money to be in a taxable account, you would end up paying 15 percent in taxable gains. We will also assume that all the gains are long-term gains, which have a significantly lower tax rate than short-term gains, and again for simplicity, we'll assume that annual income in this example is below the threshold for “high-income” earners.

After three years, in this example, you would end up with an additional $415 or 4 percent more than you would in a taxable account. The difference is even greater if you are considered a “high-income” earner by the tax code. In that case, even if all of your gains are long-term, you would have to pay 23.8 percent, which would mean that over three years, you would lose 7 percent of your return (or $655) in taxes! Remember, too, that the extra 7 percent gets to grow inside your account, compounding the benefit! (See Figure 2.2.)

Figure 2.2 Investment growth in taxable versus pretax accounts at “high-income” tax rate

      This led us to ask Sophia one of the most important questions. Just what kind of an investor are you? What kind of returns are you looking for, and what kind of risks are you comfortable taking?

      These questions, or some form of them, are the most typical questions asked by investment professionals, and are probably the most widely misunderstood, both by those asking the questions and those on the receiving end!

      What these questions are meant to discern is what style of investing most suits you, based on your personality, your comfort with risk, and your individual financial needs and goals. Start first with your investing personality. One of the best ways to figure out just what type of investing will make you more comfortable is to think of it in terms of your personality.