5 'basic' financial words you've heard — but are too embarrassed to admit you don't know
Then someone says, "My new job comes with major stock options, but they don't fully vest for four years, with a one-year cliff!" You nod like a bobblehead as they continue, "I wasn't planning on staying there that long, but to get fully vested I may hold on. That stock is hot."
Silently, you're like, "Vest"? "Vested"? All you can picture is the knitted variety.
But you're pretty sure that's not it. You're not going to slow the conversation down to ask about "stock options." Besides, now they're talking about how much their deductible has gone up on their health insurance. Check please!
Ever felt this way? We asked around and got the secret confessions of people who let financial terms whiz right past. Maybe these are words you've heard or read about, but don't quite understand. Don't worry: We got you.
1. "Stock options"
Stock options, as in a benefit from an employer, is actually an employee stock option, sometimes called ESO. This is different than trading options on the stock exchange: Those are public exchange-traded stock options. If someone around you is going on about "puts" and "calls" and talking about "Spyders," they're talking about trading options. Go here to study up on that kind.
But for now, let's stick with employee stock options: An employee stock option is an opportunity to buy a certain number of company shares during a specific time at a pre-set price. Buying stock in a company you work for has pros — and sometimes big cons, or risks.
Employers offer stock options to employees as a benefit and an incentive to perform well. Usually the employee needs to be vested (see below) to be able to take advantage of the option, or, as you may hear it referred to, "exercise" the option to buy. Because the employee's opportunity to buy comes much later than when the initial price, or "strike price," is offered, what an employee pays may be different than the company's market price in the stock market.
Here's an example from Investopedia: A new hire is offered stock options that allow him to purchase 10,000 shares of company stock at $5 a share at a later date. Once the date rolls around, the stock price has doubled to $10 a share. But the employee retains the option to buy shares at only $5.
The employee can buy 10,000 shares at $5 and sell them at $10, making a $50,000 profit. Wowza!
When you put even more zeros behind those numbers, they will look more like the stock options executives get, with millions of dollars accumulating for them as part of their compensation.
You've probably gotten a clue already: To vest, getting vested or vesting is the process of gaining ownership, over time, of the stock or contributions for retirement offered to you by an employer.
If you're offered stock options or a retirement contribution from your company, you may not get it at once. You'll get it over time according to a schedule set by your employer. If you stay on with the company for the specified amount of time, what was promised to you — stock options, restricted shares, retirement contributions — will be yours.
Once you're vested, your employer can't take the benefits away. But before that? You might be out of luck if you leave a job.
You'll only be able to walk with part of the package initially offered: the part that has vested. Here's an example, via Investopedia: You are hired with an offer of 10,000 stock options that will "vest" over five years, with a one-year cliff. English?!
This means your company is going to give you an opportunity to buy a certain amount of stock at a certain time for a certain price. But you don't get the opportunity all at once. You'll get 20% of the options each year.
And, your company stipulates you don't get anything for a year. That's what the "cliff" is. After you've worked there a year you'll jump up the "cliff" and get the 25% at once. (Sometimes after getting to the cliff, you can earn the options by the month or quarter. But for our example, let's stay with 25% a year.)
After year one you'll have 2,000 options. If you stay there for five years you'll have 10,000 options. But if you leave after two years, you'll only get 4,000. The other 6,000 options are forfeited.
Now, being "fully vested" doesn't mean you can take the money and run. You will still be responsible for any rules of a retirement plan, which generally require you to be of a certain age before withdrawing the money without penalty — or be responsible for any tax on your vested shares.
Escrow is actually a legal term more than a financial one. But the word is often used in financial transactions, especially real estate: "We will hold your earnest money down payment in escrow until your closing." Say what?
Escrow is a kind of account held by a neutral third party into which assets — like money, securities, deeds — are held. When in escrow, assets are in a safe-zone midway between transferring from one person or entity to another. The assets stay here until the conclusion of that deal. In a residential real estate transaction, finishing the deal is called the "closing."
The primary function of money in escrow is to demonstrate an ability to pay while being able to kick the tires on your planned purchase.
Here's an example: You found the house that's going to work for you. You agree on a sales price and an amount for a down payment. That is your earnest money, and it has to be ready to go. Usually within days of agreeing to the contract your deposit must be put in escrow.
But you haven't even had a home inspection yet. Your contract stipulates that you'll pay the seller that money in escrow as long as the house is in good shape. What if there is mold in the basement? What if the water heater is clanging, leaking battleship?
You'll be able to back out. And get your money out of escrow.
"Deductible" is a utility player in financial terminology. You may have deductibles related to your health insurance, car insurance or homeowner's insurance. You also have things that are deductible from your taxes and it is sometimes hard to know what is "tax deductible."
At a noun, a deductible is how much you pay out of pocket for your health care, car or home, for example, before the insurance kicks in. As an adjective, as in "tax deductible," it means expenses that you can deduct from your income, which will reduce your tax liability.
Here is an example of an insurance deductible (the noun): You have health insurance with a $200 deductible. You're in a bike accident and the cost to patch you back up is $1,500. According to your health insurance plan, you are required to pay $200 first. Then your insurance company will cover the rest, which in this case amounts to $1,300.
When people talk about their "deductibles going up," usually with an air of frustration, it means they are being asked to pay out-of-pocket for a larger share of their health care. This is in addition to what they pay monthly for the privilege of health care, which is called the premium.
Determining what is "tax deductible," the adjective, can be tough. (We help you out here). The IRS has a long list of things that are tax-deductible. As a way to reduce their taxable income, people can claim these deductions — eligible medical expenses, mortgage interest expenses and some investment expenses — against their income.
Deductions can add up, if you know where to look. Do you subscribe to magazines for your job? Did you have to buy your own uniform for work? Are you incurring expenses looking for a job in your line of work?
Those expenses are deductible. Want to know how, exactly, deducting stuff — including IRA contributions — during tax time saves you money? Read on.
5. IRA, Roth IRA (What does "Roth" mean?)
Unlike traditional retirement plans, called individual retirement accounts or IRAs, the Roth IRA allows account holders to withdraw savings tax-free. It might be far into the future — but that's going to feel good!
Roth of the infamous Roth IRA is William Roth, a Republican senator from Delaware. And you can bet that his tax-reforms to retirement savings were in the first line of his obit. The Roth IRA was established by the Taxpayer Relief Act of 1997 and signed into law by President Bill Clinton.
Both Roth and traditional IRAs are tax-advantaged accounts. The difference, though, is traditional IRA contributions are pre-tax dollars and the Roth IRA is made up of after-tax dollars — hence the tax-free withdrawals.
Here is an example from the benefits program at Carnegie Mellon University: Let's say you have an annual salary of $30,000 and you have an income tax rate of 25% while you're working. If you decide to contribute $6,000 a year to an IRA, you'll be able to deduct (more on the word "deduct" above) that from your taxes and pay taxes on only $24,000. (The numbers in this example, including the tax rate, have been simplified for explanation's sake.)
If you decide to contribute $6,000 a year to a Roth IRA, you'll wait until after you pay your income taxes. You pay taxes on all $30,000 of earnings then, after taxes, you contribute the $6,000. Thirty years later, assuming you contribute $6,000 a year and earn an annual 6% rate of return on your investment, both accounts have $474,349.
You're in retirement with a 15% tax bracket and ready to withdraw your savings. If you take the money from the IRA, you will need to pay 15% on your earnings. That takes a more-than $71,100 bite out of your nest egg — the opportunity cost of skipping a Roth account.
If you chose to invest in a Roth IRA, you pay no tax, because that income was already taxed, and your take home retirement savings is the full $474,349.
Now why would anyone ever choose an Traditional IRA? Simply: If you don't take the tax benefit of contributing to your IRA, you may not even have enough to contribute the $500 a month to any retirement account.
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