Your Money_ The Missing Manual Part 18

Based on this table, if Gillian is single and had a taxable income of $100,000 in 2009, her marginal tax rate is 28%. However, this doesn't mean that all of her income is taxed at 28%-only the amount over $82,250 is taxed at that level. The fancy way to say this is that Gillian's income is taxed progressively at each bracket up to her marginal rate. That sounds confusing, but it's actually not so bad once you know what it means. Here's the breakdown: - The first $8,350 of Gillian's $100,000 income is taxed at 10% (see the table), so she owes $835 in taxes on that portion of her income.

- The next $25,600 of her income (the amount from $8,351 to $33,950) is taxed at 15%, meaning she owes $3,840 in taxes on it.

- The next $48,300 of her income (the amount from $33,951 to $82,250) is taxed at 25%, so she owes $12,075 in taxes on it.

- The final $17,750 of her income (the amount from $82,251 to $100,000) is taxed at 28%, so she owes $4,970 in taxes on it.

Because Gillian earns $100,000 of taxable income, she's said to be in the 28% tax bracket tax bracket based on the percentage she's taxed on the last dollar she earns. But as you can see above, most of her income is actually taxed at lower rates. In fact, she ended up owing a total of $21,720 in taxes in 2009, which means her based on the percentage she's taxed on the last dollar she earns. But as you can see above, most of her income is actually taxed at lower rates. In fact, she ended up owing a total of $21,720 in taxes in 2009, which means her effective tax rate effective tax rate was only 21.72%. (And her rate could actually be lower if she had any deductions and exemptions-see was only 21.72%. (And her rate could actually be lower if she had any deductions and exemptions-see How Income Tax Works How Income Tax Works.)This info may seem esoteric and unimportant, but understanding marginal tax rates can help you make decisions when investing or taking out a mortgage. Knowing about marginal rates can also help you understand why statements like, "If I take a second job, I won't benefit because it'll just push me into the next tax bracket" aren't true. As long as there's no 100% tax bracket, there's always always a benefit to earning more money. To explore tax rates over time, check out this interactive calculator: a benefit to earning more money. To explore tax rates over time, check out this interactive calculator: http://tinyurl.com/usa-taxes.

s.h.i.+ft income and expenses In some cases, you can save on taxes by s.h.i.+fting income from one year to the next. This doesn't work if you have a steady paycheck, but it can make a difference if you're self-employed or get paid irregularly. Say, for instance, you had more than usual income in 2009-enough to b.u.mp you up a tax bracket. In that case, if you were planning to sell some stocks, you might put it off until 2010 because you figure your marginal tax rate (see the box on Know what you owe Know what you owe) will be lower then.

You can apply this same principle elsewhere on your taxes. For example, you can use some expenses for itemized deductions if they're high enough. If you have medical expenses that total more than 7.5% of your AGI (How Income Tax Works) in a given year, for instance, you can deduct the amount that's over 7.5% of your AGI. To get above that amount, it can make sense to bunch medical expenses into a single year.

NoteWhile it's good to look for clever ways like this to reduce your taxes, never make life decisions based solely on the tax consequences. Don't put off heart surgery just to save on taxes, for instance.

Hire a pro Some people are reluctant to hire others to do their taxes. If your taxes are really simple and you're good with numbers, then you may not need to hire a tax professional.

TipIf you do your own taxes, you might be able to use Free File, a program that lets many U.S. taxpayers file their tax returns electronically at no cost. (For the 2009 tax year, you can only use Free File if you made less than $57,000.) For more info, check out http://tinyurl.com/IRS-freefile.

But even if you like doing your own taxes to save money or because you think it's kind of fun (some people do!), it still might be worth hiring a pro. Professional tax advisers include tax attorneys, certified public accountants, tax preparers, and enrolled agents. To learn more about the different kinds of tax professionals, see http://tinyurl.com/taxfolks.

I used to do my own taxes. Then one year, as an experiment, I paid an accountant to do my taxes and did them on my own. The accountant earned back far more than his fee by cutting my tax bill below what I thought was due. Now I pay him every year, and I'm happy to do so.

TipIf you decide to hire someone to do your taxes, give yourself plenty of time-don't wait until April 1st to start looking!

The more complicated your taxes are, the more likely you need a pro's help. And remember that things you do throughout the year (not just at tax time) can have an impact on your taxes. So don't try to manage your money in ways that are out of your league. This is especially important before you make any big transactions (like giving money to your cousin Jim or selling a business). If you're not careful, you can run up your tax bill quickly without knowing it. If you don't understand the tax implications of a particular money move, ask a financial adviser for advice.

Don't cheat Whatever you do, never, ever cheat on your taxes-it's not worth it. Getting upset about owing money doesn't do any good; just pay your taxes and move on. Still, you should absolutely do what you can to pay only the amount you're legally obligated to pay. Take all of the deductions you're ent.i.tled to. And remember: If you owe a lot, it means you had a good year.

TipIf you don't like how high your taxes are or how they're being spent, take it up with your local politicians, not your tax professional-and definitely not the IRS.

Other moves One of the best tax moves you can make is to save for retirement by putting money into a 401(k) or an IRA. These accounts (which you'll explore in detail in Chapter13 Chapter13) are tax advantaged, meaning either contributions or withdrawals are tax free, and the money in the accounts grows tax free.

If you itemize deductions, donating to charity is another smart tax tactic. For example, you can donate your old car instead of trading it in. That way you do some good in the world, avoid the ha.s.sle of dealing with a dealers.h.i.+p, and get a tax break.

Finally, every year, visit the IRS website (www.irs.gov) or ask your tax professional to learn about any new tax credits or deductions you may qualify for. If you bought a home in 2009, for example, you may be eligible for an $8,000 first-time homebuyer's credit.

On The Money: Avoiding AuditsIt's one of the most dreaded phrases in the English language: "You're being audited." Each year, about 1% of American taxpayers get audited. When the IRS audits you, they review your tax return to confirm that everything is correct. Fortunately, if you have an average income and a normal tax return, you don't have much to worry about. (But the IRS always audits a certain number of people at random, so no one is totally safe.)Most returns are processed by IRS computers programmed to watch for anything odd. An item that falls outside the norm may be "flagged" so that an IRS employee can review it to see if there's actually a need for an audit. Common ways to raise red flags with the IRS include: - Incomplete or sloppy returns. Math errors and missing info make the IRS cranky. If the agency's computers can't make sense of what you file, they'll flag your return. And make sure all your info is the same on both your federal and state returns.

- Unreported income. This is a no-brainer: If you file a return but don't report all your income, you're headed for trouble. You have to report all your interest, dividends, and other income.

- Abnormal income. If your income is suspiciously low or high, you're five times more likely to be audited. And if your income changes drastically from year to year, that may raise a flag, too.

- Lots of itemized deductions. There's nothing wrong with claiming all the deductions you're ent.i.tled to, but be aware that if you have a lot, you're more likely to be audited.

- Being self-employed. Filing a Schedule C ("Profit or Loss from Business" form) doesn't guarantee you'll get audited, but the IRS doesn't like to see small business show losses year after year while you have a regular job (http://tinyurl.com/IRS-hobby). Home offices are a huge red flag, as are unlikely business deductions (no, that Nintendo Wii is not not a business expense). a business expense).

Honesty is the best defense against audits: Save your receipts, report all your income, and don't try to fudge things. If you're nervous about getting things right, use tax preparation software or hire a tax professional. But even if you have a pro prepare your return, review it for obvious errors. For more suggestions, check out MSN Money's page devoted to avoiding audits: http://tinyurl.com/no-audit.

What To Do If You Can't Pay Uncle Sam If you have a rough year, you may discover that you can't afford to pay your taxes. It happens. In fact, it happens often enough that the IRS has very specific instructions about what to do if you're unable to pay.

First and most important, file your tax return! Just because you can't pay your whole tax bill doesn't mean you don't have to send in the paperwork. (If you can't complete a return, then file an extension: http://tinyurl.com/IRS-extension.) Next, pay as much as you can as soon as you can. This will reduce what you'll have to pay in penalties and interest. The IRS will then send you a bill for the balance-and will continue to do so as you make regular payments.

Finally, if you're really pinched, you can use Form 9465 (http://tinyurl.com/IRS-installment) to set up an installment agreement-a payment plan, in other words-with the IRS. They can't turn down your request for an installment agreement if you owe less than $10,000, have paid your taxes on time for the past 5 years, you plan to pay the balance in less than 3 years, and you agree to cooperate with the IRS. (You also have to pledge to pay future taxes on time.) TipYou can read more about tax payment options at the IRS website: www.irs.gov/taxtopics/tc202.html.

The Pros and Cons of Refunds Every year, millions of Americans choose to have their employers withhold more than necessary from their paychecks so they'll get a tax refund at the end of the year. These people think of it as a sort of forced savings plan: If they money isn't in their paychecks, they can't spend it. Many experts hate this, and they've got some good arguments: - "You're giving the government an interest-free loan!" This may not bother you-some people like letting the government use their money for a year.

- "You're cheating yourself out of cash flow!" If you get a refund, it's because you had too much withheld from your paychecks. For some, this money could make a real difference in their day-to-day lives. If your cash flow is tight and you get a big refund, you're probably better off adjusting your withholding by filing a new Form W-4. (See The Power of Positive Cash Flow The Power of Positive Cash Flow to learn more about the importance of cash flow.) to learn more about the importance of cash flow.) - "You could invest that money at a higher rate of return!" If the government has your money until you get your refund, you can't put that cash in a savings account, a mutual fund, or CD where it can earn interest.

With so many clear reasons not to get a tax refund, why do it at all? Mostly because it's a fantastic psychological trick-it's a way to force yourself to save. By having the money automatically taken out of your paycheck so you can't touch it, you can acc.u.mulate a few hundred (or even thousand) dollars every year.

I won't tell you this is a bad idea. For years, I did the same thing. I looked forward to every March because I knew that meant a big refund-which was my only form of savings. But now I save year-round, which is a much better tactic. As described in Chapter7 Chapter7, you can "pay yourself first" by having cash from your checking account automatically put into a savings account at a different bank. This is just like using a tax refund as a forced savings plan except that you have more control over the money.

TipWondering when your refund will arrive? The IRS has a web page that makes it quick and easy to check the status of your refund: http://tinyurl.com/refund-check. You just have to provide your Social Security number, marital status, and exact refund amount.

If you get a big refund every year, consider filling out a new W-4 so that less is withheld from your paychecks. Basically, this spreads your refund out over the whole year (which is a good thing as long as you have the discipline to use this money wisely). But if a large refund makes you happy and helps you to save, then do it. Just be aware that there are better financial options when you're ready for them.

On The Money: Organizing Tax Doc.u.mentsWhen preparing your taxes (or having someone else do them for you), it can be tough to gather up all the paperwork you need. Tax-related doc.u.ments can show up any time of year, not just in the winter, and it's easy to lose important papers. Here's a simple way to keep them all together:Every January, take a manila folder and label it with the year-"Taxes 2010," for example. Then during the year, put all your tax-related doc.u.ments in the folder: investment statements, tax forms, mortgage info, receipts for charitable donations, and so on. If you'll need it to do your taxes, put it in the folder. Be sure to keep the folder someplace safe. That way, at the end of the year, it's a snap to sort these papers and submit them to your tax professional.

Where to Get More Tax Info There's no room in this book to cover important topics like estimated taxes (www.fairmark.com/estimate/) and capital gains. If you need more info, go to your local library and borrow one of those gigantic tax guides like the ones from J.K. La.s.ser or Ernst & Young; they look like phone books and are packed with info. Or dig around online at tax-related sites like: - The IRS web site (irs.gov) is surprisingly useful. It offers a library of forms and publications, an extensive list of frequently asked questions, and info on how to file for an extension. You may want to start at the Tax Topic Index: www.irs.gov/taxtopics.

- BankRate.com publishes an annual tax guide (http://tinyurl.com/BR-taxguide) that includes a handy tax calendar, forms and charts, and tips on a variety of tax topics.

- There are all kinds of useful, tax-related spreadsheets tucked on the Web. You can find two of the best at http://tinyurl.com/tax-ss and and www.taxvisor.com/taxes.

- June Walker (www.junewalkeronline.com) has created a site filled with tax and financial advice for the self-employed.

If you really need help, your best bet is to get advice from a professional tax adviser. Yes, it'll cost money, but you'll usually find it's worth the fee-and then some.

A Brief Overview of Estate Planning n.o.body likes to think about death-especially their own. Most people don't think about creating wills until they hit middle age. But you can't always see death coming and, in addition to the emotional trauma, it can wreak financial havoc on your family.

You can make things a little easier for your family and friends by planning ahead and creating a will. A will is for anyone who wants to distribute their money and possessions according to some plan. (All that you own, including physical property and investments, is known as your estate. An estate plan is a strategy for pa.s.sing your money and Stuff on to your heirs.) Wills are extremely important. They give clear, legally-binding instructions about what you want done with your a.s.sets. Simply telling your relatives what you want to happen after you die isn't enough.

NoteIf you die without a valid will or living trust (lawyers call this dying intestate), your state's laws determine what happens to your property. Generally, your Stuff will go to your spouse and children or other closest heirs, which may not be what you intended. To have your wishes respected, you have to create a will.

Depending on your situation, you may need something more than just a simple will. Here's a rundown of a few of the most common estate-planning doc.u.ments: - A will (also called a last will and testament) lets you decide who inherits your property (both land and personal possessions). This is also where you designate who you want to be your children's guardian. MSN Money has a good article on mistakes to avoid when preparing a will: http://tinyurl.com/MSN-willmistakes.

- A living will (or advance medical directive) lets you tell your family what to do if you're incapacitated and terminally ill. This is the kind of doc.u.ment you need if you don't want to be kept alive on life support. The Mayo Clinic has more info on living wills at http://tinyurl.com/LW-mayoc.NoteYou may also want to draw up a power of attorney, which gives another person the legal authority to act on your behalf if you're incapacitated. For more info, visit http://tinyurl.com/AARP-poa.

- A living trust (or revocable trust) can help your survivors avoid probate, the court process used to pay your debts and distribute your property to the people who inherit it. (Some living trusts also reduce taxes or protect financial privacy.) The older and wealthier you are, the more likely you can benefit from having a trust. (But note that, even if you have a living trust, you still need a will.) You can learn more about living trusts here: http://tinyurl.com/NOLO-livtr.

Not everyone needs a living will or a living trust, but most folks should have a will. They're the best place to note that you want certain family heirlooms to go to specific people. If you're married and have children only by your spouse, your will can be pretty simple. (If your kids are minors, you may want to specify a legal guardian.) The need for a will increases significantly in more complex situations: multiple marriages, multiple children by multiple partners, mixed families, and so on. You'll reduce hards.h.i.+ps and hurt feelings in the future if you're clear in your will about what you want to happen to your property and what you want to do for specific people.

Drawing up a Will Though modern software and various websites let you draft simple estate planning doc.u.ments yourself (see the box below), you're usually better off hiring an attorney to do it for you-especially if you have complex finances. (As comedian Jerry Seinfeld says, "A lawyer is basically the person that knows the rules of the country. We're all throwing the dice, playing the game, moving our pieces around the board, but if there's a problem, the lawyer is the only person who's read the inside of the top of the box.") Making a will isn't about walking away from a lawyer's office with a piece of paper in your hand. It's about evaluating your estate-as meager as it may be-and deciding what you want to happen to it after you die. This process is easier when somebody who knows the system is there to show you the way.

On The Money: Creating Your Own WillOver the past decade, there's been a boom in personal estate planning as people have become increasingly comfortable downloading forms from the Internet and using legal software. If you're the do-it-yourself type, here are some good places to turn for help: - LegalZoom.com is an online service that creates legal doc.u.ments. You fill out a form or questionnaire, submit it to LegalZoom, and the company uses this info to create a legal will or living trust. (They can help you with other legal doc.u.ments, too.) LawDepot.com offers similar services.

- Quicken Willmaker is a desktop program that guides you through creating your own will. Some versions can help you create living wills and living trusts, too.

- Nolo.com is an excellent source for books and software about legal topics. The site offers info on a variety of subjects, including estate planning. (Most public libraries have a good selection of Nolo books and other resources to help you prepare a will and other doc.u.ments.) Using resources like these, you can put together a simple will in under an hour. But be warned: These tools are aimed at those with basic basic needs. The doc.u.ments they produce are certainly better than nothing, but if you have a complicated estate (if you own a business or have children by a previous marriage, for instance), your best bet is to contact an attorney. needs. The doc.u.ments they produce are certainly better than nothing, but if you have a complicated estate (if you own a business or have children by a previous marriage, for instance), your best bet is to contact an attorney.If you use software or pre-printed forms to create your will, be sure to follow the signing instructions for your state. For more on do-it-yourself estate planning, read this article from the New York Times New York Times: http://tinyurl.com/NYT-wills.

A lot of people don't understand what will happen to their property when they die. For example, your retirement account-which is probably your single most valuable a.s.set after your home-is generally not governed by a will; it's covered by a completely different set of rules. (This point is very important, but most people don't realize it.) If you make your own estate plan, you may not take this sort of thing into account. And many families have been shattered by fighting that happens when a will they thought was legally binding turns out to be invalid because it wasn't properly drafted and witnessed.

A lawyer's job is to make sure everything is done properly, even if you draft the will yourself. Don't risk everything for the sake of saving a few bucks. It's better to have the doc.u.ments and not need them than to need them and not have them.

Working with an attorney to create a will is fairly simple. Just call one up and say you're interested in planning your estate and that you need more info. He'll probably sit you down for an interview or give you a series of forms to fill out. My wife and I recently had an attorney draft our wills; you can see his blank will-planning doc.u.ment here: http://tinyurl.com/GRS-will.

The more organized you are, the easier the process is. Once the attorney has an idea of what you own and where you want it to go after you die, he'll draw up the paperwork. Though most wills share certain features, the attorney will customize it for your specific needs.

TipIf you want to know how much an estate plan will cost, ask. The price depends on where you live and how complicated your estate is.

In a way, preparing a will is sort of anti-climactic. There's not a lot of legal mumbo-jumbo or red tape. You simply gather info, answer a few questions, and sign on the dotted line. For some people, there's more to estate planning than just creating a simple will, but for many, it really is this easy.

Once you have a will, keep it someplace safe and accessible, like a safe-deposit box, and let trusted family members know where it is. If your family can't find your will, they can't follow your wishes.

Finally, remember to update your will when things change. For example, when you first draft a will, you might designate your siblings as beneficiaries. If you get married, you'll probably want to change that. And if you get divorced, you'll want to change it again.

Your Money And Your Life: Estate Planning Is No JokeMatt Haughey is the 37-year-old computer whiz behind the popular site Metafilter.com. Like many young folks, he'd never given much thought to estate planning-it was something for retired people to worry about. Matt and his wife had basic wills, but discussing anything more seemed like a sort of morbid joke.They're not laughing anymore.Last fall, without warning, Matt pa.s.sed out at home and had a seizure. A trip to the ER revealed the bad news: Matt has a brain tumor. "I have a walnut-sized tumor sitting on my pituitary gland, at the base of my brain," he says."I was really mad at first. I've done my best to live well and eat right, but this is just one of those random things. Having death issues at 37 sucks. I didn't expect to have to deal with this for another 20 years."Suddenly, estate planning is a priority. "After I got out of the hospital, we stopped talking about it and started doing something," Matt says. "We made an appointment with an estate attorney and spent 3 hours talking about this stuff." In addition to his will, Matt now has a living trust (A Brief Overview of Estate Planning).Matt is glad he hadn't completely completely neglected planning for the future. "Thank G.o.d that after my daughter was born, I took out a 20-year, million-dollar term life policy," he says. "The process was simple: I filled out an online questionnaire, and then a nurse pract.i.tioner came to my house to take a blood sample. After a few days, I was approved. The insurance costs like five or six hundred dollars a year. I just have to remember to pay the bill when it comes every September." neglected planning for the future. "Thank G.o.d that after my daughter was born, I took out a 20-year, million-dollar term life policy," he says. "The process was simple: I filled out an online questionnaire, and then a nurse pract.i.tioner came to my house to take a blood sample. After a few days, I was approved. The insurance costs like five or six hundred dollars a year. I just have to remember to pay the bill when it comes every September."No matter how old you are, if somebody else depends on your income, you need life insurance (Matt's experience has shown him that it's important to have good health insurance, too). If you have children or any sort of estate, you need a will. And if you own a business or have sizeable a.s.sets, you may need a living trust."My number-one piece of advice for estate planning is to do it while you're healthy do it while you're healthy," Matt says. "Last summer, this was all sort of a joke: writing down the chain of command of who gets the house or retirement accounts if our entire family were to perish. Now it's not a joke, and it involves a lot of painful questions and deep thinking. When you're unexpectedly faced with the very real possibility of death, it sucks."

PartIII.

Building a Rich Life

Chapter12.An Intro to Personal Investing.

"Investment performance doesn't determine real-life returns; investor behavior does."-Nick Murray Wall Street is filled with jargon and with folks like Jim Cramer shouting at the TV camera, telling you to "Buy! Buy! Buy!" and "Sell! Sell! Sell!" But when it comes time to invest your money, it's hard to know where to start. Stocks? Bonds? Commodities? And what are those things exactly, anyway?

Investing doesn't have to be complicated. In fact, the investing method covered in this chapter-a method recommended by Warren Buffett and scores of other investment pros-takes just a few hours up front, and then a few hours a year thereafter. This method offers solid returns and you don't need a degree in finance to understand it.

As you'll learn in this chapter, smart investing is simple but not easy-human nature gets in the way. And before you invest a penny, you should understand some essential terms and concepts. Let's get started.

NoteThis chapter gives you the basic info you need to get started with investing. For a closer look at investing and to learn more great strategies, check out Bonnie Biafore's Personal Investing: The Missing Manual Personal Investing: The Missing Manual. As with all things financial, the more you know, the better.

Why Invest?

Chapter5 taught you how to spend less on many kinds of things, and taught you how to spend less on many kinds of things, and Chapter6 Chapter6 suggested various ways to increase your income. Together, these two steps can lead to positive cash flow and a monthly surplus of money that can improve your life. But although improving cash flow is the best way to build wealth in the short term, it probably won't be enough to let you meet your long-term goals. suggested various ways to increase your income. Together, these two steps can lead to positive cash flow and a monthly surplus of money that can improve your life. But although improving cash flow is the best way to build wealth in the short term, it probably won't be enough to let you meet your long-term goals.

For one thing, many long-term goals are expensive. You want to put your kids through college, right? According to the College Board's Trends in College Pricing (http://tinyurl.com/col-costs), it cost over $23,000 for a young adult to attend the average 4-year private school during the 200708 school year. That's plenty expensive already, but in recent years, college tuition costs have risen at about twice the rate of inflation. How will you be able to afford that?

And don't forget retirement. As you'll learn in the next chapter, you'll need a lot of money to retire. Just how much you'll need depends on your income, spending habits, when you start saving (the sooner the better!), and how long you live. But it's unlikely you'll have enough if you just stick your money in the bank-you need a little help from the extraordinary power of compounding.

NoteCompounding is the s...o...b..ll effect that happens when your money earns interest over long periods of time. You earn returns not just on the amount you contributed, but on your earnings, too. To learn more about compounding, see the box on The Power of Compounding The Power of Compounding.

Lurking behind all your plans for the future is inflation, your silent enemy. Inflation refers to the rising price of things; it's the reason a movie ticket that cost 10 cents in your grandpa's day now costs $10. Just as compounding in your bank account can help your savings grow bigger and bigger, the compounding effects of inflation constantly nibble at your wealth, making it worth less and less.

From December 1984 to November 2009, inflation averaged 2.96% per year. That probably sounds like just another boring statistic, but it's a number that has a real impact on your life. Because of compounding (which is working against you in this case), $100 from 1984 is worth only $48.68 today; in other words, you'd need $205.44 now to buy what $100 could get you 25 years ago.

As a rule of thumb, inflation is roughly equal to what you can earn in a high-interest savings account. So even though your money grows thanks to compounding, it's almost like you're swimming against the tide: You paddle forward as fast as you can, but inflation keeps dragging you back so you just stay in the same spot.

Savings accounts are great for short-term goals; inflation may do a little damage, but it doesn't have time to compound. If you want to achieve your big goals over the long term, you need to do more than just boost your cash flow and stick money in savings. The best way to do this is to invest in the stock market because, over the long-term, stocks offer the best possible return. (When talking about investments, your return is the amount you earn or lose.) How Much Do Stocks Actually Earn?

In his book Stocks for the Long Run Stocks for the Long Run (McGraw-Hill, 2008), Jeremy Siegel a.n.a.lyzes the historical performance of several types of investments (economists call them a.s.set cla.s.ses). He tries to answer the question "How much does the stock market actually return?" After crunching lots of numbers, Siegel found that since 1926: (McGraw-Hill, 2008), Jeremy Siegel a.n.a.lyzes the historical performance of several types of investments (economists call them a.s.set cla.s.ses). He tries to answer the question "How much does the stock market actually return?" After crunching lots of numbers, Siegel found that since 1926: - Stocks have returned an average of about 10% per year. Over the past 80 years, stocks have produced a real return (meaning an inflation-adjusted return) of 6.8%, which also happens to be their average rate of return for the past 200 years.

- Bonds have returned about 5%. Adjusted for inflation, their real return has been about 2.4%.NoteYou'll learn about stocks and bonds starting on The Tools of Investing The Tools of Investing.

- Gold has a real return of about 1%. "In the long run, gold offers investors protection against inflation," writes Siegel, "but little else."

NoteSiegel doesn't mention it but, according to my calculations, real estate has also returned about 1% per year since 1926.

Siegel goes back even further than 1926, showing that if you'd invested just one dollar in stocks in 1802, it would have been worth more than $750,000 in 2006. If you'd put that dollar in bonds instead, it would have grown to just $1,083. And if you'd put it in gold, it would be worth $1.95. (All those figures take inflation into account.) "The dominance of stocks over fixed-income securities [like bonds] is overwhelming for investors with long horizons," Siegel writes. In plain English: Over the past 200 years, stocks have outperformed every other kind of investment. But before you rush out and sink your savings in the stock market, you need to understand a few important points.

NoteQuick reminder: A bull market is a period of generally rising stock prices, and a bear market is a period of generally falling prices.

Average is not normal Stocks offer handsome returns because they involve a lot of risk, meaning their value can fluctuate a lot (that's why they're described as volatile). The most important thing to know about stocks is that their average performance is not normal.

While it's true that stocks returned an average of about 10% annually (which works out to about 7% after inflation) over the past 80 years, in only two of those years have actual returns been close to average. Recent history is more typical. The following table shows the annual return for the S&P 500 (see the Note below) over the past 15 years: Table12-1.The average annual return for the S&P 500 for these 15 years was 6.07%.

S&P 500 Annual Returns .

1995.

34.11%.