15 Key Financial Terms to Know to Plan a Successful Future

Editor's Note: This story originally appeared on NewRetirement.

When a new year begins, it always feels like an opportune time to reassess your personal finances. If you’re wanting to take a comprehensive look at your financial picture, you may be digging through investment statements, tax documents, insurance policies, and, of course, you will likely be revisiting your plan in the NewRetirement Planner.

Through your review, you will likely come across a lot of financial jargon, and understanding its relevance to your personal finances is essential. Personal finance doesn’t need to be complex and you deserve to have a clear understanding of your financial picture.

Whether you’ve been managing your finances for decades or are just starting out, familiarity with these terms is valuable for planning your financial future.

Below is a rundown of some of the commonly misunderstood terms in the categories of investments, taxes, insurance, retirement planning, and estate planning.

Navigating the world of investments can be complex. You’ve likely come across these terms while reading about investments or looking through your investment statements.

Asset class

An asset class refers to a grouping of investments that share similarities with each other and set them apart from assets in other classes.

Broadly speaking, assets within a particular asset class will present similar characteristics to one another (such as risk and potential for return), perform comparably under certain economic conditions, and behave in a similar fashion in their respective markets.

The three most common types of asset classes that you are likely very familiar with are:

• Stocks: When you buy stock, you purchase a share (or shares) in a company. Stocks can also be referred to as equities.
• Bonds: When you buy a bond, you are essentially loaning money to a corporation or government who has promised to pay it back at a certain time. Bonds can also be referred to as fixed income, because they typically provide a fixed or predetermined stream of income to the bondholder.
• Cash: Everyone knows what cash is!

While these are the most common asset classes, there is also real estate, alternative investments like hedge funds, and commodities like gold and silver.

A well-diversified portfolio can help alleviate the impact of poor performance in any one asset class.

Expense ratio

You’ll want to be aware of your expense fees of the funds you are invested in within your portfolio.

The expense ratio is the cost of owning a mutual fund or exchange-traded fund (ETF). It reflects how much the fund you are invested in pays for portfolio management, administration, marketing, and distribution, among other expenses. You’ll likely see it expressed as a percentage of the fund’s average net assets, rather than a flat dollar amount.

The benefits of being a passive investor include the low costs of investing in index funds and ETFs. According to the Investment Company Institute (ICI) 2022 report “Trends in the Expenses and Fees of Funds, 2022”, the average expense ratio for index equity mutual funds was 0.05% and the average equity ETF expense ratio was 0.16% in 2022.

Expenses diminish the investment returns you generate, underscoring the importance of conducting thorough research to compare a fund’s expense ratio with those of similar funds offered by competitors. Morningstar is a good resource for conducting this research.

Basis point

If you tune into CNN or other market news regularly, you may have heard the term basis point.

A basis point is commonly used to measure percentage changes in interest rates, stock market movements, bond yields and more. One basis point equals 1/100th of a percentage point. For instance, if you hear that a stock’s value increased by 50 basis points, that means its price rose by 0.50%.

Now that you can drop basis points in future financial conversations at dinner or retirement parties, everyone will be coming to you as their investment guru!

Taxing Tax Terminology

Taxes play a substantial role in most areas of your finances, and understanding the following terminology will better prepare you for getting through another tax year.

Effective tax rate

It is a common misconception that your marginal tax rate (the highest bracket your income puts you in) is what you pay in taxes. You actually pay an average, and this average is called your “effective tax rate.”

The effective tax rate is typically calculated as an average across all taxes paid, including income taxes, capital gains taxes, and other taxes. It takes into account the total tax liability divided by the taxpayer’s total income. This provides a more comprehensive picture of the overall tax burden on an individual or entity, considering various types of taxes rather than focusing solely on one specific tax category.

Example: Here is an example if you are ONLY paying income tax and assuming that your filing status is single and your taxable income is $150,000. In 2023, you would be paying 10% on the first $10,275, 12% on the next $31,500 ($41,775 – $10,275 = $31,500), 22% on $47,300 ($89,075 – $41,775 = $47,300) and 24% on $60,025 ($150,000 -– $89,075 = $60,925).

Your effective tax rate is the total amount you pay in taxes divided by your taxable income:

Effective tax rate = Total tax ÷ Taxable income

TCJA and tax rollback

The Tax Cuts and Jobs Act (TCJA) was a significant piece of tax legislation that was signed into law in December 2017. It introduced sweeping changes to the U.S. tax code, impacting both individuals and businesses. Among other things, TCJA reduced individual income tax rates.

This legislation is set to expire at the end of 2025, with tax rates returning to pre-2017 levels at the start of 2026.

Model the TCJA Rollback in the NewRetirement Planner: Because taxes can be a significant retirement expense, the NewRetirement Planner enables you to toggle between and model the different projections using either:

• The current lower tax rates
• The possibility of returning to the higher rates that were used in 2017 starting in 2026.

This tax rate toggle is found in My Plan > Assumptions. Switching between these rates is useful when looking at projected expenses, considering Roth conversions, and more.

Cost basis

When you are investing in a taxable brokerage account, it’s essential that you are aware of the cost basis in your investments.

In general, your cost basis is the original investment amount for tax purposes. This is usually the purchase price, adjusted for reinvested dividends and capital gains and any commissions or transaction fees you paid.

When you sell an investment at a profit in a taxable brokerage account, you only pay taxes on the gain, which is the positive difference between its current selling price and the cost basis of your investment. An accurate cost basis ensures you will report future realized capital gains and losses on your tax return appropriately, which we’ll discuss further below.

NOTE: In the NewRetirement Planner, when you enter an after-tax account (e.g., taxable brokerage account) that holds stock funds, you will need to enter a cost basis for that account. This article from our Help Center describes how to identify the cost basis of your after-tax account.

Capital gains tax

Capital gains tax most often applies when you are investing in a taxable brokerage account. When you sell an investment at a capital gain, or profit, then your capital gain is taxed.

The amount of taxes you pay depends on how long you hold your investment.

If you hold your investment for one year or less, you would have a short-term capital gain, which is taxed at your ordinary income tax rates, up to 37% for 2024. If you hold your investment for more than one year, you have a long-term capital gain, which is taxed at lower capital gain tax rates, up to 20% in 2024.

NOTE: In the NewRetirement Planner, the turnover rate for your after-tax accounts with stock funds represents any selling that happens within the account and may incur capital gains taxes. The tool will take the account balance and cost basis, realize that percentage of gains, and tax them at your long-term capital gains rate.

FICA (Federal Insurance Contributions Act)

The Federal Insurance Contributions Act (FICA) levies two taxes on employees (and also employers and self-employed individuals). One tax is for Old-Age, Survivors, and Disability Insurance (OASDI), commonly known as the Social Security tax, and the other is for Hospital Insurance, commonly known as the Medicare tax.

As an employee, FICA taxes are a payroll deduction that is automatically taken out of your paycheck. There’s a maximum amount of compensation subject to the Social Security tax, but no maximum for Medicare tax.

For 2024, if you are working as an employee, you will pay:

• 6.2% Social Security tax on the first $168,600 of wages, plus
• 1.45% Medicare tax on the first $200,000 of wages ($250,000 for joint returns, $125,000 for married taxpayers filing separate returns), plus
• 2.35% Medicare tax (regular 1.45% Medicare tax plus 0.9% additional Medicare tax) on all wages in excess of $200,000 ($250,000 for joint returns, $125,000 for married taxpayers filing separate returns)

Although no one likes paying mandatory taxes, by paying into Social Security and Medicare, you are contributing to your own retirement and healthcare benefits for the future.

NOTE: You can rest assured that FICA is calculated using your projected work income and current tax rates and caps in the NewRetirement Planner.

Ensuring Your Understanding of Insurance Terms

When it comes to risk management, you want to make sure you don’t risk not having a full understanding of insurance jargon that can be applicable to your personal financial situation.

IRMAA (Income-Related Monthly Adjustment Amount)

IRMAA relates to premiums you are paying while on Medicare. It is an additional fee levied on top of the basic Medicare Part B and D premiums for those above certain annual income thresholds. Your IRMAA amount depends on your tax filing status and income.

Medicare premiums are assessed on a year-to-year basis, based upon your Modified Adjusted Gross Income (MAGI) from two years prior to the current year – the 2024 premiums are determined based on 2022 data.

The MAGI threshold changes annually with inflation and the threshold is actually a cliff, meaning one dollar over the limit can incur a surcharge for the entire year. There are five tiers of Medicare surcharges based on these income thresholds.

To calculate MAGI for Medicare IRMAA, take your Adjusted Gross Income (AGI) and add tax-exempt interest. Tax-exempt interest is usually any municipal bond income.

NOTE: To determine if IRMAA will have an impact on your Medicare premiums, you can head over to Insights > IRMAA in the Planner.

Coinsurance

Choosing health insurance coverage for the year isn’t easy when you are coming across terms like coinsurance in your research.

Coinsurance refers to shared costs between you as the policyholder and the insurance company of covered healthcare expenses after the deductible has been met. You’ll usually see it expressed as a percentage.

Let’s take a look at an example:

• You have a health insurance plan with a coinsurance provision of 20%
• The deductible is $2,000
• You incur medical expenses totaling $4,000 for the year
• You are responsible for paying the initial $2,000 (deductible) out of pocket before the insurance plan kicks in
• With a 20% coinsurance rate, you would be responsible for 20% of the remaining $2,000 in covered expenses, or $400
• The insurance company would cover the remaining 80%, or $1,600

Generally speaking, health insurance plans with low monthly premiums have higher coinsurance, while plans with higher monthly premiums have lower coinsurance.

Elimination period

An elimination period, also known as a waiting or qualifying period, is the duration you must wait after the onset of an illness or disability before you can start receiving insurance benefits from a disability or long-term care insurance policy.

For example, if you are thinking about purchasing a long-term care insurance policy, when you choose your elimination period you are agreeing to pay for any charges during that time.

Generally, the longer the elimination period, the lower the premiums.

Simplifying Retirement Lingo

For many reading this, you may already be retired or retirement may be just around the corner. So, it’s important to understand these more common terms that you may have come across in preparing for a successful retirement.

RMD (required minimum distribution)

A required minimum distribution (RMD) is the amount of money that must be distributed (or withdrawn) from an employer-sponsored retirement plan funded with pre-tax contributions, such as a 401(k), traditional IRA, SEP account, or SIMPLE individual retirement account (IRA) by the account holder upon reaching a certain age.

The RMD rules are designed to make sure that people spend a portion of their retirement savings during their lifetimes, making the accounts tax-deferred, not tax-free. Your annual RMD will shift depending on your age, life expectancy, and account balance.

Depending on your birth date, the RMD age will look as follows, if you are born:

• Before 1/1/1951, your RMDs have already started and nothing changes.
• Between 1/1/1951 and 12/31/1959, then your RMDs must start at age 73.
• After 1/1/1960, then your RMDs will begin at age 75.

Your RMDs are taxed as ordinary income, just like a salary.

The NewRetirement Planner shows you the impact that RMDs will have on your plans. You can now use the Planner to:

• See projected RMDs for each year on the Lifetime Income Projections chart, Savings Insights, and/or Income & Expenses Insights
• PlannerPlus users can use Tax Insights to assess the impact of RMDs on tax thresholds

SWR (safe withdrawal rate)

You’ve likely come across this retirement decumulation strategy if you have been researching ways to reliably pull from your portfolio, ensure your spending keeps up with inflation, and remain reasonably assured you’re not in danger of running out of money in retirement.

The 4% rule put forth in 1994 by William Bengen is the best-known safe withdrawal rate. Using this rule of thumb, in retirement you would withdraw 4% of your total investment portfolio in the first year of retirement, and increase annual withdrawals solely for inflation. Through this strategy, retirees are presumed to have a low risk of running out of money over a 30-year retirement.

Through the years, there have been revised safe withdrawal rate rules of thumb, based upon future estimates of inflation and returns. Research from prominent companies like Morningstar continues to be done to further evaluate this strategy.

Sequence of returns risk

Upon retirement, you transition into the withdrawal phase, tapping into the money you’ve saved and invested for income. This involves initiating 401(k) or IRA withdrawals and potentially liquidating investments in your taxable account.

Sequence of returns risk arises from the specific order in which investment returns occur. It is the risk that the market may undergo a downturn, leading to lower returns, precisely when you begin the decumulation phase of retirement.

Awareness of sequence risk is essential, as it can directly affect the longevity of your retirement savings.

Don’t Forget About Estate Planning

Estate Planning isn’t often the most exciting item on the financial to-do list, but it plays such an essential role in building a strong financial foundation.

Probate

Probate is like the referee of the legal world, ensuring that when someone passes away, their wishes and assets are handled fairly and according to the rules. It’s a court-supervised process that involves validating the deceased person’s will, or if there isn’t one, deciding how to distribute their property and settle debts.

The probate process will distribute property per court order, following state laws, in cases where there is no Will.

Probate has the potential to be a complex, time-consuming, expensive, and public process. Establishing a comprehensive and well-thought-out estate plan can significantly minimize the complexity of this process, and in certain situations, it might even enable your loved ones to bypass it entirely.

Revocable trust

A trust is an estate planning document that involves three parties: a Trustor (or Grantor), a Trustee and a beneficiary (or beneficiaries). It’s set up by a Trustor to give a Trustee authority to hold and manage assets on behalf of your named beneficiary or beneficiaries.

A common trust type is a revocable trust, or revocable living trust. This type of trust gives you control during your lifetime. As the Trustor or Grantor, you have the power to change the arrangements of the trust. With a revocable trust, you are able to avoid probate, the costly and complex public process discussed above.

Various types of trusts are available, and the most suitable one for you will depend on the size of your estate, your objectives, and the legacy you aspire to create.

However, while a trust may be a good idea for some people, it is not necessary for everyone.

Intestate

Dying intestate is like leaving the final chapter of your life story blank.

In more formal terms, the word “intestate” means passing away without having a valid will or any specific instructions on how you’d like your assets distributed.

If you die intestate, courts will step in and use state succession laws to determine who should benefit from your estate. You essentially have zero control over what happens to both your estate and to your loved ones after you pass away.

As you may have seen in the news over the years, there are many celebrities who have died intestate. Protecting you and your family by creating an estate plan is such an important part of a comprehensive retirement plan.