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What Is A Mutual Fund?

Published: July 2015

Mutual funds are investment vehicles commonly employed by many Americans -- in fact, there's more than $15 trillion invested in 9,000 funds in the U.S, according to Statista.

Mutual funds are a common offering in many company-sponsored 401(k) plans. If you're working on your retirement savings plan, it can help to understand the basics of mutual funds, to see whether they're an option you might want to invest in.

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Mutual Fund Basics

According to the Securities Exchange Commission (SEC), a mutual fund is a company that pools money from many investors and invests it in stocks, bonds, and/or other securities. This creates a portfolio of holdings, of which investors can purchase shares. Each share represents an investor's partial ownership of the fund's portfolio, and the right to enjoy proportional gains or income from those holdings. In short, when you invest in a mutual fund, you are entitled to a share of any gains (or losses), such as dividends, interest income, says the SEC.

One of the many benefits of mutual funds, says the Financial Industry Regulatory Authority (FINRA), is built-in diversification — that is, mutual funds can invest in a wide variety of securities, thus reducing the investment risk associated with having all or most of your money in a single investment. By owning mutual fund shares, you can spread your money across a variety of stocks or other securities.

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Generally speaking, FINRA says, mutual funds can be classified in the following ways:

  • Stock funds invest in stocks. Some funds may seek to cover only a certain industry or sector, such as technology or health care, while other stock funds may seek broader diversification across an entire market index, such as the Standard & Poor's 500 or NASDAQ. Still others might invest in certain world regions, such as a Europe or Asia stock fund.
  • Bond funds, as the name suggests, invest in bonds. Like stock funds, they may focus on any particular type of bond, such as municipal or global bonds, for example.
  • Balanced funds invest in a combination of stocks and bonds.

Active vs. Passive Management

One other mutual fund distinction to note is whether a fund is actively or passively managed.

When a fund is actively managed, says FINRA, it employs professional portfolio managers to select the investments, with the goal of out-performing the market. Such funds might be a good choice for investors who seek professional selection and management of their fund's investments. The SEC and FINRA note, however, that actively managed funds often have higher fees, in part due to the professional portfolio management.

By contrast, notes FINRA, passive funds aren't actively managed — instead, they merely seek to mirror and replicate (not beat) the returns offered by the index they track. For example, the manager of a fund that mirrors the S&P 500 would just buy a portfolio of the stocks in that index in the same proportions to replicate the S&P 500's holdings. Since the fund merely mirrors the index — and doesn't employ professionals to make active investment choices — passive funds such as these often have much lower fees.

Ultimately, the question of which mutual fund — or funds — to invest in is a highly personalized one based on your individual risk tolerance and other financial factors. And since mutual funds are offered in most 401(k) or self-directed IRA plans, they're also a convenient starting point for retirement investing.

Speak with your financial professional and consult a fund's information packet, known as its prospectus, before deciding which funds are right for you.

2. There are a few exceptions to the early-withdrawal penalty.

Note those two little words: a few. The IRS may let you off the hook for the 10 percent penalty early-withdrawal penalty if you’re a qualified first-time homebuyer (withdrawals may not exceed $10,000) for example, or if you need to pay medical insurance premiums while you’re unemployed. A few other exceptions apply with regard to higher education expenses and military reservists.

3. You must start taking withdrawals by age 70½.

A traditional IRA is intended for use during retirement — thus the name Individual Retirement Account. So, the IRS requires you to crack open your nest egg when you reach age 70½. You have until April 1 of the following calendar year to make an initial withdrawal. How does that work? Let’s say you turn 70½ on June 30, 2016. You can delay the first withdrawal until April 1, 2017. If you do wait until the following year, however, there may be tax implications (see No. 5).

4. You must withdraw a minimum amount every year.

It’s called the required minimum distribution (RMD), and the IRS provides a worksheet to help you calculate the figure on its website. Of course, you can take more than the RMD if you want. The point is, if you skimp on your RMD, or skip it altogether, you may have to pay a 50 percent excise tax on the amount you failed to withdraw.

5. Delay your first withdrawal until the calendar year after you turn 70½, and you’ll end up taking two withdrawals in the same year.

Why? Because the IRS requires you to take out money annually no later than Dec. 31 beginning in the calendar year after you turn 70½. So if you reach 70½ on June 30, 2016, and choose to delay your initial withdrawal until April 1, 2017, you’ll be required to take a second distribution later that year. While it might be exciting to have more money in hand, both withdrawals will be taxed on your 2017 returns. If you want to avoid the double whammy, it’s better to take the initial withdrawal in the same calendar year you turn 70½.

These are some of the basics for managing a traditional IRA withdrawal. If you need help managing your IRA to make the most out of your retirement, talk to a financial advisor.

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This content is for informational purposes only and may not be applicable to all situations.

You should carefully consider the investment objectives, risks, charges and expenses of mutual funds before purchasing shares or investing money. Additional information about these and other subjects can be found in the mutual fund prospectus. To obtain a prospectus, please contact your Allstate Personal Financial Representative. Please read the prospectus carefully before purchasing shares or sending money.

Securities offered by Personal Financial Representatives through Allstate Financial Services, LLC (LSA Securities in LA and PA). Registered Broker-Dealer. Member FINRA, SIPC. Main Office: 2920 South 84th Street, Lincoln, NE 68506. (877) 525-5727. Check the background of this firm on FINRA's BrokerCheck website.
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