Glossary

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If you own an asset that increases in value, any increase in value is a paper profit, or unrealized gain. If you sell the asset for more than you paid to buy it, your paper profit becomes an actual profit, or realized gain. The same relationship applies if the asset has lost value. You have a paper loss until you sell, when it becomes a realized loss.

You owe no capital gains tax on a paper profit, though you use the paper value when calculating gains or losses in your investment portfolio, for example. The risk with a paper profit is that it may disappear before you realize it. On the other hand, you may postpone selling because you expect the value to increase further.

You collect passive income from certain businesses in which you aren't an active participant. They may include limited partnerships where you’re a limited partner, rental real estate that you own but don’t manage, and other operations in which you’re an investor but have a hands-off relationship. Neither earned investment nor investment income from dividends, interest, or capital gains is considered passive income.

You have passive losses from businesses in which you aren't an active participant. These include limited partnerships, such as real estate limited partnerships, and other types of activities that you don't help manage.

You can deduct losses from passive investments against income you earn on similar ventures. For example, you can use your losses from rental real estate to reduce gains from other limited partnerships. Or you can deduct those losses from any profits you realize from selling a passive investment.

However, you can't use passive losses to offset earned income, income from your actively managed businesses, or investment income.

A defined benefit pension is a retirement plan set up by a corporation, labor union, government, or other organization to provide retired employees with a specific income — either as a lump sum or as an annuity — for the rest of their lives.

The pension amount typically depends on the employee's age at retirement, final salary, and the number of years on the job. Details of the pension are explained in the plan document. An employee's surviving spouse is also entitled to receive at least 50% of the pension benefit for life unless he or she waives that alternative in writing.

Many traditional pensions — otherwise known as defined benefit plans — have been replaced by defined contribution or cash balance plans. In some of these arrangements, employers put money into retirement funds for their employees, without guaranteeing the retirement benefit the employee will receive. In others, employees defer current income into the plan, and the employer may or may not provide a matching contribution.

If you own more than one security, you have an investment portfolio. You build your portfolio by buying additional stocks, bonds, annuities, mutual funds, or other investments. Your goal is to increase the portfolio's value by selecting investments that you believe will go up in price.

According to modern portfolio theory, you can reduce your investment risk by creating a diversified portfolio that includes different asset classes and individual securities chosen from different segments, or subclasses, of those asset classes. That diversification is designed to take advantage of the potential for strong returns from at least some of the portfolio’s investments in any economic climate.

Most lenders allow you to prepay the outstanding balance of a loan at any time without a fee, but some lenders charge a prepayment penalty, which is usually a percentage of the amount you borrowed. If your loan agreement doesn’t have a prepayment clause, which excludes a fee for early termination, the penalty may apply.

Many states prohibit prepayment fees, and they’re not allowed on any mortgage loans purchased by Fannie Mae or Freddie Mac. But they are allowed in other states, and lenders may offer a lower rate on loans with prepayment penalties because they are locking in their long-term profit.

Similarly lenders who offer to waive closing costs and points when you refinance may impose a penalty if you pay off the loan within the first few years. But if you’re not planning to move, this refinancing deal could save you money.

A pretax contribution is money that you agree to have subtracted from your gross income and put into a retirement savings plan or other employer-sponsored benefit plan. Your taxable earnings are reduced by the amount of your contribution, which reduces the income tax you owe in the year you make the contribution. Pretax contributions to retirement plans, such as 401(k), 403(b) or 457(b) plans, are taxed when you withdraw the amount from your plan.

Principal can refer to an amount of money you invest, the face amount of a bond, or the balance you owe on a debt, distinct from the finance charges you pay to borrow. A principal is also a person for whom a broker carries out a trade, or a person who executes a trade on his or her own behalf.