Retirement Watch : stock

How to Revise Your Retirement Plan

Bob Carlson — Thu, 03 Sep 2009 17:25:00 GMT

Despite the rally in stocks and other risky assets since March 9, many portfolios are still damaged from the events of the last few years. For those who are retired or near retirement, one step you have to take after such an event is to re-evaluate your retirement plan, especially your spending. Specifically you have to check the rate at which you plan to withdraw money from your retirement portfolio and decide if it needs to be adjusted to reduce the risk of running out of money.

Financial planners spend a lot of time contemplating the safe or sustainable withdrawal rate. This is the percentage of the portfolio you can withdraw the first year, increase the dollar amount by inflation each subsequent year, and have a high probability the portfolio will at least 30 years. The biggest risk to a retirement portfolio is a bear market or a long-term flat market in the early years of retirement. The second biggest risk is to withdraw money at an unsustainable rate.

Numerous studies indicate that to be safe, the first year withdrawal rate should be between 3% and 4% of the portfolio. The most commonly-cited sustainable rate is 3.6%. This assumes you invest at least 50% of the portfolio in stocks or assets that earn similar returns. If you invest a lower percentage in growth assets, the sustainable withdrawal rate is lower.

If you are fortunate enough to retire at the beginning of a bull market, a higher withdrawal rate is safe. But you won't know until after a few years of retirement the type of market that coincided with the beginning of your retirement.

Whatever withdrawal rate you choose the first year, the rate needs to be re-evaluated periodically. Even the 3.6% withdrawal rate does not allow a portfolio to last 30 years 100% of the time. There still is a risk of running out of money.

When portfolio returns are disappointing, you need to re-evaluate the plan to be sure you aren’t on track to run out of money. Bear markets are followed by bull markets, eventually. The key is to be sure the combination of the bear market and your spending does not bring the portfolio balance so low the subsequent bull market gains are not enough to sustain the portfolio through retirement.

If you retired a few years ago and still have a portfolio that is worth more than your starting portfolio, you probably are in good shape. The research shows you should be able to continue your planned withdrawal schedule with a very low probability of outliving your money. You might want to reduce spending a bit for the next few years to be on the safe side, but drastic measures are not needed unless there is another significant downward leg to for your portfolio.

What if you now have less money than when you first retired? In that case, you need to consider changes. We will review some potential changes shortly. First, let's look at more objective benchmarks of your spending rate.

One way to evaluate your spending rate is to assume an immediate single-premium lifetime annuity is purchased with your entire retirement portfolio. Is the annual payout from that annuity similar to the amount you are withdrawing now? If you are withdrawing significantly more than the annuity payment, you likely will have a problem sustaining the withdrawal rate unless investment returns increase. Insurance companies spend a lot of resources calculating life expectancies and determining how much they can pay a person and still make a profit. If your withdrawals are significantly higher than what the insurers are paying, then you are assuming a significantly higher investment return or shorter life expectancy than the insurers. Keep in mind if you have a spouse you intend to provide for, the portfolio likely will have to last longer than for a single life annuity. Check annuity payout rates at web sites such as www.ImmediateAnnuities.com

Another objective warning sign is a withdrawal rate approaching 10%. Surveys continue to show that many people think they safely can withdraw 8% to 10% annually. Research does not back that up, except in strong bull markets.

Here’s another quantitative measure.

One study found a strong correlation between the safe withdrawal rate for the next 30 years and the current price/earnings ratio of the S&P 500. The higher the P/E ratio, the lower the safe withdrawal rate is for the next 30 years. P/E ratios tend to be high at bull market peaks, followed by years of below-average returns.

A simple rule is that when the P/E ratio is above the historic average, the safe withdrawal rate is on the low side. When the P/E ratio is low, withdrawal rates can be higher. When the P/E ratio is below 12, a withdrawal rate of 6% or more generally is safe. At extreme bear market bottoms, a rate of 10% can be sustained going forward. Right now, the P/E ratio is around the historic average and not near historic lows.

If your portfolio has declined and you are concerned how long it will last at the current spending rate, there are steps you should consider. One or more of these steps should put you back on the right track.

Drop the inflation bump. The studies of the safe withdrawal rate all assume that after the first year the amount taken from the portfolio each year increases with inflation. A simple step is to stop the inflation increase for a while. With consumer prices falling, that makes sense anyway.

Use a market-based formula. Instead of a formula that steadily increases spending, have spending rise and fall with the portfolio, though not by as much. One simple formula is to set your withdrawal rate, but apply it to the average account value at the end of each of the last five years.

Another option is what I call the Yale Endowment formula. Each year 70% of the distribution is the initial spending amount plus inflation. The other 30% is a fixed percentage of the portfolio's value. More details of the formula are in my book The New Rules of Retirement.

These formulas smooth distributions. They have the disadvantage of automatically reducing spending when the portfolio declines, but that makes the portfolio last longer. They also have the advantages of increasing spending as investment returns improve, and the cuts are not as drastic as the portfolio’s changes.

The safety fund system. Another approach I have recommended is to create a safety fund at the start of retirement. You put an amount equal to the estimated spending for two to five years in safe investments such as money market funds and certificates of deposit. The rest of your portfolio is invested for the long-term. You take money from the safety fund to pay expenses. At the end of the year you rebalance the long-term portfolio by replenishing the safety fund.

The advantage of the safety fund approach is that you do not feel pressured to sell investments after a steep decline, because you know there is enough money in safe assets to get through the two to five year period. Those who do not have large enough portfolios to create a safety fund should consider purchasing an immediate annuity with a portion of their portfolios. Because of low interest rates now is not an optimum time to put a lot of money in an immediate annuity, but as rates rise it is a good long-term strategy.

Change allocations and strategies. Retirees whose past investment strategies have let them down should consider changes. Some portfolios were too heavily weighted to equities instead of being diversified (though there were few asset classes that did not lose money in 2008). Other investors could benefit by shifting from buy-and-hold to the more active strategies of our Managed Portfolios.

Most retirees are able to vary spending. They can postpone travel, spend less on restaurants and entertainment, and replace cars and other items less often. Spending adjustments are the best way to get a retirement portfolio and spending back on track.

When secular bear markets strike early in retirement and put the longevity of your portfolio at risk, adjustments are needed. First, adjust spending. You can reduce it for only a year or two or consider making a permanent change to the spending formula. Second, reconsider your investment policy. Do not give up on growth or risk or take too much risk, but be sure your strategy fits today’s markets.

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site www.RetirementWatch.com. He also is author of the books The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Hedge Funds for the Rest of Us

Bob Carlson — Thu, 23 Jul 2009 15:41:00 GMT

Hedge funds used to occupy a small, obscure part of the investment world. They were out of the public eye; few investors even knew about them. Regulators ignored them, as a matter of law.

Gradually hedge funds became more prominent. A few of the pioneers of the business became billionaires, drawing attention to the business. George Soros received a lot of publicity in the 1990s after winning a big bet against the British pound, a move that British officials lambasted and blamed for the fall of the pound.

Hedge funds really took off after the technology stock bubble burst in 2000. While market indexes declined, many hedge funds held their value or made money. That attracted not only media attention but a flood of money from pension funds, endowments, and other sophisticated investors. It seemed that everyone who did well on the trading desk of a Wall Street firm or who had the confidence of a broker formed a hedge fund and raised tens of millions of dollars to invest. Some hedge funds grew to billions of dollars under management, and some hedge fund owners earned $1 billion and more in a year.

While hedge funds in general did not distinguish themselves in the broad market crash of 2008, they have a reputation for beating the S&P 500 long term and generally have done so in 2009 to date.

The problem for most investors is they cannot invest in hedge funds. By law, a hedge fund can accept only certain investors, known as qualified investors. They also are known as sophisticated investors. These investors are pension funds, endowment funds, foundations, and individuals who meet net worth or income requirements. But there are some safe ways for individual investors to reap the rewards of hedge fund investment strategies.

There is no real definition of a hedge fund, though there used to be. Today, a hedge fund is an investment partnership or pool that is not subject to the regulations that apply to mutual funds, investment advisors, or brokers. Hedge funds are subject to only a few regulations. That is why they can accept only certain types of investors. Those who wrote the securities laws reasoned that these sophisticated investors did not need the protection of the securities regulators and could invest with whatever firm they wanted to.

The original hedge fund was an investment vehicle that took both long and short positions in the stock market. A long position is when an investor buys an investment expecting it to appreciate. A short position is when the investor sells short an investment, expecting it to depreciate. The investor also can use futures or options contracts to take long or short positions in an investment. In other words, a hedge fund actually hedged its investments. It would take a long position expecting an investment to increase but also would take a short position that would profit if the long position did not.

Today the term hedge fund applies to a fund’s legal status rather than its investment strategy. Hedge funds today engage in a wide range of investment strategies. Some have very conservative strategies that aim to earn only a little more than money market interest rates. Other hedge funds employ very risky strategies, even using debt or other forms of leverage that magnify gains or losses.

Hedge funds have several features that attracted institutional investors in recent years.

An important characteristic of a hedge fund is that its investment returns have a low correlation with the major stock and bond market indexes. Correlation is the extent to which an investment rises or falls with an index. Some investors call this “beta.” An investment with a beta of 1.0 to a stock market index rises and falls when the index does and by the same percentage. An investment with a beta of 0.0 to the index has no correlation with it. An investment with a beta of -1.0 moves exactly the opposite of the index.

Correlation is important, because an investor might not want his portfolio’s value to be subject to the ups and downs of the stock market. While the long-term average returns are nice, the investor might not be able to withstand the shorter-term declines of 20% and more, sometimes much more. An endowment or foundation must pay income each year to fund its sponsor. A pension fund must pay pension annuities, and the employer’s annual contribution is based on the current value of the fund. An individual might be paying for retirement or some other expense, and cannot plan well with sharp fluctuations in the portfolio’s value. Each of these investors has good reason to seek an investment that does not have a high correlation with the stock market indexes.

An investment with a high long-term return that does not fit the same pattern as the stock market indexes is a good addition to a portfolio.

Hedge fund investors also like that they can build a diverse portfolio of hedge funds that have low correlations with each other. When some funds are up, others are down. This combination of investments with low correlations to each other also smoothes a portfolio’s returns.

Another advantage of hedge funds is they can be less volatile than the stock indexes. While the stock indexes have wild disparate returns from year to year, a number of hedge funds have much steadier return patterns. This is another way of smoothing the portfolio’s annual changes in value.

Investment returns are another appeal of most hedge funds. The ideal hedge fund has long-term returns that are close to those of the stock indexes but has a low correlation with the index and less volatility than the index.

This is all interesting, but what does it mean for you unless you are a qualified investor? There are ways you can benefit from hedge fund strategies.

A few years ago I set out to build a portfolio of no-load mutual funds that have the same characteristics as hedge funds. The return patterns of the funds would have low correlations with the major stock and bond indexes and also with each other. The funds as a group also would have less volatility than the indexes and would have high long-term returns.

Not too long ago, it would have been impossible to put together such a portfolio. Mutual funds had “long only” portfolios. They did not use unusual strategies, sell short, or hedge. They also did not move from one type of asset to another. In general, traditional mutual funds stuck to one type of investment and strategy, and they did not hedge their investments.

Even better, my “hedge fund” mutual funds do not have the high expenses of hedge funds. A typical hedge fund charges annual expenses of 2% of assets plus an incentive fee of 20% of all positive returns. That is how hedge fund managers make high incomes. You do not need to earn high returns to earn a high income if you have a lot of assets under management and take 20% of all positive returns.

I put the hedge fund portfolio together in 2001 and back-tested its performance. The performance since has been consistent with the back-testing and the goals. The portfolio returns more than the S&P 500 with less volatility and a low correlation to the index.

The key to a long-term successful portfolio such as this one is to avoid the large losses of the indexes. While 2008 was a rough one for my “hedge fund” portfolio, it was better than for traditional mutual fund investors and for many well-known hedge funds.

The big picture numbers of the portfolio are impressive. The volatility, as measured by standard deviation, is 10.75 over three years, 8.7 over five years and 7.73 over 10 years. In each case, the volatility is about half that of the S&P 500. (All the data are as of June 30, 2009.)

The portfolio also has a low beta, or correlation, with the S&P 500, though that has increased the last few years. Over three years the beta is 0.52, and it is 0.51 over five years. Over 10 years the beta is 0.36.

Returns are excellent. Alpha is the extent to which the returns exceed those of the benchmark. The portfolio consistently delivers alpha over the S&P 500. Over three years, alpha is 3.01 annually, and it is 2.93 over five years. Over 10 years, annual alpha is 5.88.

The financial crisis of 2007 and 2008 increased the standard deviation and beta, because all assets were negatively affected by the market meltdown and credit squeeze, except treasury bonds. I expect over time those numbers for the shorter periods will become closer to those of the 10-year period, as they were before 2008.

One of my goals for any investment is to avoid big losses. We cannot avoid all losses, but we want to avoid those 40% and 50% draw downs to which the market indexes are subject. The hedge fund portfolio has accomplished this.

Over the one-year period, the portfolio lost 9.12%. That is disappointing, but it is much better than the 26.21% loss of the S&P 500. Over three years the portfolio has a positive return of 0.30% annualized, versus an annualized 8.22% loss for the index. Over 10 years we have a 7.26% positive annualized return instead of the 2.22% annualized loss of the S&P 500.

Normally a portfolio that avoids large losses also misses out on bull markets. That is not the case with this portfolio. The highest returning period of the last 10 years was the three months ending with May 2009. The hedge fund portfolio earned 16.27% during this period. That lags the historic returns the S&P 500 earned during the period, but it is a strong return and coupled with the portfolio’s loss reduction qualities puts the portfolio well ahead of the index. The worst three-month period for the portfolio, not surprisingly, was the period ending November 2008 with a 20.63% loss. The worst 12 months ended February 2009 with a 22.78% loss, and the worst three years ended Feb. 2009 with a 4.43% annualized loss. Losses of that magnitude are disappointing, but they are well above the index and what most investors sustained. The portfolio bounces back with the markets.

The hedge fund portfolio is diversified among not only strategies but also different types of assets. As of June 30, 2009, the portfolio was 7.37% in cash, 37.52% in U.S. stocks, 9.22% in non-U.S. stocks, 43.04% in bonds, and 2.85% in other assets.

The funds in the portfolio are carefully selected for several characteristics. They must be no-load and have reasonable expenses. They also must use strategies commonly used by the best hedge funds instead of typical mutual fund strategies. The funds also must have low correlations with each other and with the major indexes.

The hedge fund portfolio is designed as a buy-and-hold portfolio. Changes are made when newer funds prove themselves after a few years or when an existing fund has a major change, such as its management or fee structure. But generally we depend on the fund managers to move their portfolios among different asset classes instead of doing it ourselves.

The portfolio has a wide variety of mutual funds. There are traditional hedge funds, such as Schwab Hedged Equity. There also are “asset allocation” funds such as Hussman Strategic Growth and PIMCO All Asset. There are some unique balanced funds, such as Oakmark Equity and Income, FPA Crescent, and Berwyn Income. The portfolio also has funds that can invest in almost anything but specialize in distressed asset investing. Finally, we have some funds that invest in long only strategies but do so in assets that offer good diversification, such as real estate investment trusts, high yield bonds, and international bonds.

Investors have been damaged by following conventional investment strategies of buying and holding portfolios of long-only mutual funds that invest in many of the same assets. There are opportunities to achieve true diversification and construct portfolios that deliver better returns than the S&P 500 with less volatility and risk. These results can be achieved using select no-load mutual funds that avoid the high fees and lack of liquidity of traditional hedge funds while employing traditional hedge fund strategies.

Dos and Don'ts of IRA Investing

Bob Carlson — Fri, 03 Apr 2009 14:18:00 GMT

Many people own substantial IRAs and have the bulk of their investment portfolios in IRAs. Some of these investors might not realize there are investments that are prohibited from IRAs and others are allowed but incur tax penalties. The issue of how to invest an IRA is more important in today's climate, because "hard assets" and other nontraditional assets—those that investors prefer today—are primarily those prohibited or discouraged in IRAs.

IRA investment disincentives fall into three categories. There are prohibited investments, taxable investments or transactions, and prohibited transactions.

The prohibited IRA investments are labeled “collectibles.” When an IRA purchases a collectible, the amount used to make the purchase is treated as distribution to the owner. It is included in the owner's gross income, and if the owner is under age 59½ and does not qualify for one of the exceptions, a 10% early distribution penalty is imposed on top of the income taxes. In addition, there is a penalty each year the IRA continues to own the prohibited investment.

Collectibles are defined in the tax code as works of art, antiques, rugs, stamps, coins, metals, gems, and alcoholic beverages. The IRS is allowed to define other items as collectibles but has not done so.

Note that an IRA may purchase securities of firms that produce collectibles, such as mining companies and alcohol producers or distributors. But the IRA may not purchase the collectibles themselves.

There are other investments an IRA may own, but those investments could cause the IRA to owe income taxes on income from the investments or the owner might be taxed as though distributions were made.

An IRA is most likely to be taxed when it earns unrelated business taxable income (UBTI). The UBTI rules apply to all qualified retirement plans, not just traditional IRAs. If an IRA earns UBTI exceeding $1,000 it must pay income taxes on that income. The IRA might have to file Forms 990-T or 990-W. It also must pay estimated income taxes during the year if the UBTI exceeds $500.

The IRA owner essentially will be taxed twice on UBTI. The IRA will be taxed on the income. Subsequently, the owner or beneficiary will be taxed on distributions of that income. There is no deduction or credit available to the owner for UBTI paid by the IRA, and the tax on the IRA does not increase the tax basis of the IRA.

The UBTI rules are supposed to prevent a tax-exempt entity such as an IRA from unfairly competing with tax-paying businesses. The rules are fairly broad, however, and apply to situations in which the IRA is not operating a business. An IRA potentially has UBTI if it does any of the following:

operates a trade or business,

receives certain types of rental income,

receives certain types of passive income from a business entity it controls,

invests in a pass-through entity, such as a partnership, that conducts a business, or

uses debt to finance investments.

A "trade or business" is any activity carried on for the production of income from the sale of goods or performance of service. Any business is considered unrelated to the exempt purposes of an IRA or other retirement plan. Fortunately, the tax code specifically excludes certain types of income from the definition of trade or business income for UBTI purposes. The exempt types of income include interest, dividends, capital gains, and profits from options transactions. Royalties also are generally exempt.

Even exempt income, however, can be converted into UBTI.

Real estate rental income generally is exempt from UBTI, but becomes UBTI if the amount of rent is computed as a percentage of the tenant's profits.

Controlling a business entity also can convert exempt income into UBTI. When an IRA has greater than 50 percent control of a business entity, any rent, interest, or royalties paid by the entity to the IRA is UBTI if the payments have the effect of reducing the business income of the entity. Another way to look at this rule is that if the business entity deducts the payments to the IRA, they are UBTI to the IRA.

When an IRA owns an interest in a pass-through business entity (partnership or limited liability company), the IRA's share of the entity's income is UBTI. Pass-through entities generally do not pay federal income taxes. Instead, their income and expenses are passed through to their owners' income tax returns.

This rule most often trips up individuals who invest in master limited partnerships (MLPs) or real estate partnerships in their IRAs. MLPs are traded on major stock exchanges, and many people think of them as being the same as corporate stock. In fact, these are partnership units, and the income and expenses of the partnerships pass through to the owners at tax time. Individuals generally are urged not to purchase MLPs through IRAs.

It is not illegal to own an MLP through an IRA. The ownership, however, triggers the UBTI rules and the requirement to possibly file a version of Form 990 and pay estimated taxes. There is no tax advantage to owning MLPs through an IRA. Some tax advisors recommend taking the easier and cheaper route of reporting any IRA-owned pass through items on the individual tax return instead of filing a separate Form 990 for the IRA.

An IRA also has UBTI when debt is used to finance investments. Any type of income can become UBTI when debt is used to finance the property that generates the income. For example, if an IRA receives a margin loan from the custodian or broker, income generated by the securities purchased with the loan proceeds would be UBTI. Real estate mortgages also are debts that convert exempt income into UBTI. An IRA can own real estate and earn rental income, and that rental income will be tax deferred. If the real estate is financed with a mortgage, however, the rental income becomes UBTI.

The prohibited transaction rules are the final category of taboo investments. The rules are fairly detailed and can get complicated. Generally they prohibit transactions between the IRA and its owner or a person related to the owner (including businesses).

The penalty for violating the prohibited transaction rule is severe. The entire IRA will be considered fully distributed when the prohibited transaction was made. The IRA owner must include its full value in gross income, regardless of the amount of the prohibited transaction. If the owner has multiple IRAs, only the IRA that engaged in the prohibited transaction is penalized. Other IRAs escape the penalty unless they also engaged in prohibited transactions.

It is easy to state the prohibitions in clear, plain English: No deals are allowed involving the IRA and the owner or a person related to the IRA or its owner. Yet, there are some "prohibited transactions" allowed by IRS regulations or rulings, and IRA owners can receive waivers from the Department of Labor for specific transactions.

A detailed discussion of the prohibited transaction rules would be too much for this posting. While it is possible for an IRA to engage in transactions with the owner’s small business, real estate, or other interests, such transactions should not be considered without good tax or legal advice.

IRAs do not have complete investment freedom. IRA owners who prefer investments other than publicly-traded stocks and bonds and mutual funds need to be wary of the potential pitfalls.

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site www.RetirementWatch.com. He also is author of numerous books and reports, including The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Time to Stop Deferring Taxes?

Bob Carlson — Thu, 19 Mar 2009 17:34:00 GMT

Conventional investment advice has been turned on its head by changes in the fundamentals of the economy and markets. Now, fundamental changes in the government, demographics, and the economy are forcing changes in tax policy and tax planning advice.

The age-old advice is to defer taxes whenever possible and for as long as possible. Over the years, I have pointed my subscribers to a few exceptions to this strategy discovered in our research. Soon, the classic rule might become a relic. For many people, the best tax planning advice in coming years could be to pay income taxes as early as possible, because rates will be higher later.

The structural changes leading to this conclusion are significant:

We have a new President and Congress. They explicitly campaigned on promises to raise taxes, at least on the wealthiest Americans. "Wealthy" tends to be defined downward after an election, and that is likely to be the case now.

Social Security and Medicare cannot be sustained under current tax and spending policies. Either benefits must be reduced or taxes raised or both.

The policy response to the financial crisis was for the federal government to bailout, subsidize, insure, and otherwise commit to spending a lot of money. There is a chance some money will be recovered from the government's "investments," but most likely the government will have net negative cash flow.

The new government leaders plan to spend a lot more money, especially on medical care, energy, and the environment. The details are not clear at this point, but higher spending by the government clearly is part of the plan.

Environmental policy is likely to include significant tax increases.

A result of the current crisis likely will be less leverage in the economy, leading to lower economic growth. Lower growth means less tax revenue from the current tax structure and a need for higher taxes.

The President proposed a few specific tax increases in his budget plan, but others won't be known for a while. We do have a lot of clues, however, and can begin to plan.

Higher income individuals are likely to face higher income taxes. During the campaign the income cut-off for higher taxes initially was $250,000. But at times lower numbers were used, and Congress traditionally defines “high income” much lower than $250,000. The current plan is to let the 2003 tax cuts expire after 2010, which will affect many taxpayers.

All Americans are likely to be hit with indirect and non-income taxes. These include gasoline taxes, other carbon and energy taxes, and various fees and charges.

Means-testing is another likely form of tax increase. Already upper income people receive a lower return on their Social Security taxes and pay higher Medicare premiums. Benefits from Social Security and Medicare likely will be reduced above some income level. Expect similar actions in other government programs.

Tax benefit reductions also are likely in lieu of tax rate increases. Itemized deductions and personal and dependency exemptions now are reduced at higher incomes, effectively increasing tax rates. Congress likely will search for other tax breaks to phase out as income rises. Many phase outs were included in the economic stimulus law that recently was enacted. Related changes will be "closing loopholes" by eliminating deductions and income exemptions.

A long shot in the short term is imposition of a value added tax or some kind of a national sales tax. This tax can be hidden in the cost of goods and services, raised easily, and will generate a lot of money for the government.

Taxes on long-term capital gains are likely to rise above their current 15% level. A rise to 20% seems almost certain after 2010, and an increase to 28% is possible. Taxes on dividends also will rise. The question is whether they will be taxed the same as long-term capital gains or will return to being taxed as ordinary income.

The bottom line is reduced benefits, higher taxes, and fewer opportunities to reduce taxes. Most people should plan to spend less, save more, and work longer.

A good guess is that most over age 55 won't have to deal with lower benefits from Social Security and Medicare, except those with higher incomes. Those farther from retirement likely will face changes.

What should you do?

The good news is the economic crisis prevents the imposition of higher taxes for a year or more. That gives you time to plan.

IRAs and retirement accounts likely will be hurt by future tax increases. All distributions are ordinary income, and you cannot spend the money without taking a distribution.

In the past I showed subscribers when it makes sense to pay taxes early on an IRA by either emptying it or converting to a Roth IRA (if adjusted gross income is $100,000 or less). These strategies will be profitable now for more people if income tax rates rise. In 2010 and later years under current law anyone will be able to convert a traditional IRA to a Roth IRA.

More people should give serious thought to emptying their IRAs early or converting to Roth IRAs. Details are in the members section of my web site and in my book The New Rules of Retirement.

It is too soon to sell appreciated capital assets to avoid higher taxes. A retroactive capital gains tax increase is unlikely. The government wants to tell investors in advance that the tax will increase, because the announcement will trigger asset sales by people seeking to lock in the lower rate, boosting government revenue. Be ready to sell appreciated assets in a year or two to avoid higher capital gains taxes, and expect lower after-tax returns from capital assets after that.

The same advice applies to dividends. There won't be much you can do to avoid the eventual increase. Factor lower after-tax income from dividends in your plans. As the tax rate on dividends increases higher after-tax income might be available from bonds or other income investments.

Reconsider plans to defer future income. Your income tax rate in the future is likely to be higher than today. You could have more money in the long-term by paying taxes today and investing the after-tax amount.

That means you should review IRA and 401(k) contributions and deferred compensation arrangements. Those earning $50,000 or less probably won't be hit with higher income tax rates and can safely continue tax deferrals. But the higher your income is above $50,000, the greater your risk of paying higher rates in the future. Income tax rate increases might very well be retroactive at some point. In a rising income tax regime, it is better to pay taxes today than in the future.

Forget the notion you will be in a lower tax bracket in retirement. Many of us will be in higher tax brackets, especially when all types of taxes are included. This is another reason to reduce tax deferral.

Retirement spending plans should be revised to reflect higher costs. If you are not already retired, consider working longer and saving more. You might have to pay more for medical care, utilities and other energy-using services, and more. Your Social Security benefits might be reduced because of means-testing. As the tax proposals become more specific and are closer to enactment, investment plans will need to be revised or you will have to accept lower after-tax returns.

Bob Carlson is editor of the monthly newsletter and web site Retirement Watch (www.RetirementWatch.com). He also is the author of The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

The Wealth Effect, Your Portfolio, and Your Retirement

Bob Carlson — Fri, 27 Feb 2009 14:26:00 GMT

The net worth of Americans is declining. That is no secret, though the extent of the decline will surprise many. The decline has affected and will continue to affect the economy, stock market, and your portfolio. The Federal Reserve gives a picture of the net worth of Americans every quarter, in a report known as the flow of funds data, and it is worth periodically studying the report.

The report for the third quarter of 2008 (which does not include the steep declines of October and November) was an eye-opener. It also does not include the losses from the Bernie Madoff scam and other frauds that have come to light, though they are a small percentage of the total.

U.S. household net worth declined by $2.8 trillion in the third quarter of 2008. Not only is that a large number, but it is the fourth consecutive quarterly decline in net worth. When the data for the fourth quarter of 2008 are issued it will be the fifth straight quarterly decline.

Over those four quarters of declines, net worth has declined $7 trillion, a 15.3% decline in net worth in one year. By comparison, the 1974 bear market in stocks generated a 13.8% decline, and the bursting of the technology stock bubble in 2001 led to only a 10.9% fall in net worth.

Remember that this is a report of net worth. All asset values are totaled and liabilities subtracted to arrive at net worth. Despite the high level of debt in the U.S. and substantial decline in asset values, the asset values of Americans still are substantial enough to result in a positive net worth.

Here is the real eye-opener in the report. In the third quarter Americans were so alarmed by the decline in asset values that they actually reduced their debts. This has not occurred since the data were first reported in 1952. In the third quarter, household borrowing, mortgages, and consumer credit fell at a $117.4 billion annual rate. Granted, that is a drop in the bucket compared to the asset values and amount of debt outstanding. But it does show a significant change in Americans' behavior and thinking.

Part of the decline in debt can be explained by defaults shrinking the amount of debt outstanding and by tighter lending standards reducing the amount of new debt. But part of the decline was due to consumer decisions.

For the first time in a while, Americans own less of their home equity than lenders do. A few years ago, homeowners owned roughly 60% of the value of their homes. At the end of the third quarter they owned only 44%. The rest was secured by debt, essentially owned by the lenders.

The decline in debt also reverses a factor that helped boost the economy in the first years of this century. As home equity values increased, Americans borrowed part of the equity and used the proceeds to buy things. These home equity withdrawals allowed spending to increase faster than income. That boosted GDP.

Now that process is in reverse. Shrinking home equity means people cannot borrow against it to increase spending. Paying down debt means there is less spending than income will support. The declines in net worth and debt overshadow by a large amount the recent decline in gasoline prices that many expect to increase consumer spending.

The influence net worth has on spending and borrowing is known as the wealth effect, and it is important to understand.

Many people believe that Americans spend based on their incomes, but a more important determinant of spending is net worth, or perceptions of net worth. As people perceive themselves to be wealthier, they spend more. An increase in asset values stimulates additional spending above income increases. People will spend more than their income if they believe their net worth is increasing. Some analysts estimated that in the boom years Americans were spending about $1 trillion more annually than was supported by income increases.

The key to understanding the wealth effect is that there always is a lag in consumers' perceptions of their wealth. It takes them a while to realize that market prices have changed their wealth. Most people do not follow asset price changes on a regular basis, and they often assume that price changes are temporary. Also, if the decline in one asset is offset with a rise in another asset by the time consumers review their situations, perceptions of wealth won't change.

The lag in the wealth effect is why consumer spending did not decline as much as economists expected after the technology stock bubble burst in the early 2000s. It also explains why consumer spending held up after real estate prices peaked in 2005 and after the credit crunch began in the summer of 2007.

In the third quarter of 2008 consumers finally realized the declines in asset prices were both serious and not likely to be temporary. They reduced debt and increased savings. They will continue to increase savings to make up for these asset declines until asset prices increase.

The wealth effect is another of the ways this economic cycle is different from those of the last 26 years. I believe many consumers will not ignore the recent declines in their homes and portfolios. They won't keep spending in the belief that the net worth decline is short term. Instead, I think we will see changes in consumer saving and spending that will last for at least a few years. This will reduce economic growth below what most models forecast and make it harder for the economy to rebound. It also will be very tough on retailers, luxury goods and services sellers, and others who benefit from high consumer spending.

If you want to know how bad things became in the fourth quarter, the next Federal Reserve Flow of Funds Report is due March 12, 2009.

Because of the wealth effect, we should not expect a sharp recovery in either the economy or equity markets. It also makes it likely that even after the economy reaches a bottom, economic growth and stock returns will be lower than the averages. That means you will want a different portfolio than the one that worked before the markets peaked.

Bob Carlson is editor of the monthly newsletter and web site, Retirement Watch, available at www.RetirementWatch.com. He also is the author of The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Asset Declines=A Planning Opportunity

Bob Carlson — Fri, 13 Feb 2009 19:33:00 GMT

There is at least one silver lining in today's dark clouds—estate planning opportunities are being created. Falling market prices and low interest rates are a great combination for estate planners. If the price depression of the assets is temporary, there is the potential to transfer significant future wealth at a substantial tax discount.

You probably have been postponing estate planning, because of uncertainty about the law and the value of assets. In 2009 or perhaps 2010, the estate tax law probably will be made permanent. The President essentially favors making the 2009 law permanent: A lifetime estate tax exemption of $3.5 million and a top tax rate of 45%. Some details might change, but the final law should be close to that.

Another advantage is that the annual gift tax exemption is indexed for inflation and rose to $13,000 as of Jan. 1, 2009. Each person can give up to $13,000 free of gift taxes to any person in 2009. The tax-free gifts can be made to as many people as you want. A married couple can give $26,000 jointly. In addition, the first $1 million of all lifetime gifts by a person above those sheltered by the annual exclusion are exempt from gift taxes. To the extent the $1 million gift tax exclusion is used, the estate tax exclusion is reduced.

Today's relatively low asset prices highlight a reason to give assets now instead of later through the estate.

Estate and gift taxes are imposed on the value of property. If a mutual fund has declined in value, you can give more shares tax free than you could have before the decline. For example, Dodge & Cox Stock was valued at $132.63 on Feb. 1, 2008. You could have given 90.47727 shares of the fund to someone tax free using the $12,000 annual exclusion. At the recent price of $67.48 you could give 177.8305 shares if you wanted to give $12,000 worth, or 192.6497 to take advantage of the new $13,000 limit. After the financial crisis and economic decline end, the share prices will recover. The future appreciation above the $67.48 price would be out of your estate and into the hands of your heirs with no estate or gift taxes.

This strategy applies to real estate, small business interests, and other assets that have declined in value over the last year or two. If the steep declines of the last year are temporary, this is a rare opportunity to shift assets out of your estate at a fraction of their real or long-term value.

Before giving an asset, however, determine your tax basis in it. Under gift tax law, your heirs will take a tax basis equal to the lower of your basis and the market value at the time of the gift. If the asset has declined below your basis, it makes sense for you to sell it, deduct the loss on your tax return, and give the cash proceeds from the sale. Or if you are concerned that the heirs will spend a cash gift, buy an investment that is not substantially identical to the one you sold and give that new asset. That generates two tax benefits. You deduct the current loss against your income, and all future appreciation is out of your estate.

The best assets to give are those in which you do not have a paper loss but that are likely to appreciate significantly once the financial and economic situation improves. By giving such assets you are likely to transfer the maximum amount of wealth to future generations at the lowest tax cost.

Because of the potential to shift a significant amount of future appreciation to your loved ones at today's relatively low values, it makes sense to give more than the $13,000 gift tax exemption and begin using the lifetime $1 million gift tax exemption. If you do not need the assets to maintain your standard of living and know you eventually will leave them to your children or other heirs, consider making the gifts now. You will be able to transfer far more assets tax free at today's values than you could have in the recent past and than you will be able to after appreciation resumes. Your heirs will end up with far more wealth, because the taxes on your estate will be much lower than if you retained the assets and let them be taxed as part of your estate.

Those are the basics for taking advantage of today's economic distress. Next week we will discuss ways to leverage these strategies and the current economic environment.

Bob Carlson is editor of the monthly newsletter and web site Retirement Watch at www.RetirementWatch.com. He also is the author of The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

What is Ahead for 2009

Bob Carlson — Tue, 10 Feb 2009 19:32:00 GMT

Major structural changes have occurred in the economy and markets, and more changes are on the way. The failure of Lehman Brothers was a watershed event. Investors stopped making even routine transactions, bailing out of even money market funds. The effects froze the economy and greatly worsened the effects of the credit crisis. We moved from the collapse of housing prices to a widespread economic decline. It is clear now that the effects will not be short-term. There also are longer-term effects beyond the credit crisis that should influence your portfolio choices.

Some of the long-term changes from the crisis I have identified include:

Deleveraging by consumers, investors, and business will continue. The trend persists because asset prices still are declining and credit is tight.

After the crisis, the economy will not return to the pre-crisis levels of leverage. Many people and businesses will not want to take on that level of risk. Even those that do will have trouble obtaining credit.

Less leverage means lower economic growth.

Investment returns are likely to be lower than in the past few decades for several reasons. Economic growth is the driver of long-term investment returns, and GDP growth will be lower. Returns from investments are the risk-free rate, or treasury bill rate, plus a premium for taking risk. The risk-free rate currently is bouncing around zero and even after the crisis ends will be below levels of recent decades.

Also, the negative equity returns of the last 10 years will make investors more risk averse. It will be a long time before investor enthusiasm pushes investment prices to extremely high valuations.

The bottom line is the equity risk premium will be lower than since 1982. The ERP is the return of stocks above the risk-free rate. Investors have been burned and are extremely pessimistic, so they will be less willing to pay high prices for stocks. Also, the aging population alone will make investors more income- and safety-oriented and less equity- and growth-oriented.

Stocks have higher dividend yields than the 10-year treasury yield for the first time since 1958. Through 1958 it was normal for stocks to yield more than bonds, because investors believed they needed to be compensated for the higher risks of stocks. I think dividend yields will be more important to investors in coming years.

Much of the world's economic growth is likely to be in the emerging economies, especially in Asia. For many years these have been high risk, low cost producers that depended on the western economies for growth. They are developing middle classes with internal consumption, and over time that will make them less dependent on the western world for growth. Also, they have decreased risk by improving their financial systems and government financing.

There also have been some structural changes in the markets that favor change in your portfolio. There are a host of new tools that allow individual investors to invest in sectors and assets previously closed to them. These tools enable an investor to come closer to producing a portfolio with true diversification, one in which assets are not highly correlated with each other. There also are new analytical tools and approaches to investing that help reduce risk and better balance portfolios.

I recommend changing your portfolio in two stages.

The first stage is to get us through the current crisis by having a high level of safety in your portfolio. I am not anticipating a near-term turnaround in the economy or the financial crisis. You need to be prepared for continued deleveraging, disruptions in the credit markets, and unpleasant surprises from businesses and in the economic data. There will be bear market rallies, and I suggest you take advantage of them to sell riskier assets at prices above the lows and move into a safer portfolio. It is hard to tell how long you should stay in the safer portfolio. I moved Retirement Watch subscribers there late in December. It might last a few more weeks or a few years. It depends on when the credit markets and economy start to heal.

In the second stage, move into riskier investments. But build a more diversified portfolio than many people generally have. There are four major economic trends: falling economic growth, rising economic growth, falling inflation, and rising inflation. You want to be sure part of the portfolio will do well in each of these environments. We are able to do that like never before because of the new investment vehicles. Plan the portfolio now, but wait for the current crisis to be nearing its nadir before implementing it.

Bob Carlson is editor of the monthly newsletter and web site Retirement Watch at www.RetirementWatch.com. He also is the author of The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Taking Advantage of the 0% Capital Gains Tax Rate

Bob Carlson — Fri, 30 Jan 2009 22:21:00 GMT

For the two lowest tax brackets, the tax rate in 2008 through 2010 is 0% for qualified dividends and long-term capital gains. This compares to the 15% top rate others will pay on those types of income. Single taxpayers with taxable income up to around $33,000 and married couples filing jointly with taxable incomes up to about $65,100 qualify for the 0% rate. The 0% rate applies to any long-term capital gains that qualify for the 15% rate for other taxpayers, not to just to gains on publicly-traded stock.

But there is a lot of confusion and misunderstanding about the 0% tax rate.

It is not an all-or-nothing situation. Because the tax rates are graduated, even some taxpayers with incomes above the threshold could have some income taxed at the 0% rate.

Many retired couples have taxable income below $65,100. Suppose a couple normally has taxable income of $30,000. In 2009 they realize a long-term capital gain of $70,000, bringing their taxable income to $100,000. The first $35,100 or so of that capital gain is taxed at the 0% rate. The rest of the gain is taxed at the 15% rate.

Keep in mind that interest from tax-exempt bonds is not counted in determining the threshold, so well-off taxpayers can qualify some or all of their qualified income for the 0% rate.

This situation provides opportunities for low-bracket retirees to realize some long-term capital gains on asset they otherwise might not held and pay a 0% rate on at least part of the gains. There also is an incentive to switch some investments to dividend-paying stocks that qualify for the 15% rate for other taxpayers.

Another opportunity presents itself for taxpayers who are supporting parents in a low tax bracket. The taxpayers could give some appreciated securities to the parents, who sell them and pay 0% tax. The amount given should stay within the annual gift tax exclusion amount of $13,000 to avoid owing gift taxes or using part of the lifetime gift tax exemption.

Gifts of appreciated securities also could be made to children in low tax brackets, but the gifts would have to be made to adult children. Congress changed the law on the Kiddie Tax to prevent high income parents from giving securities to their minor children to sell and pay 0% capital gains taxes. To avoid the restrictions, the children must be over 21, or over 23 if they are full-time students. The restrictions also can be avoided if the children do not qualify as dependents on their parents’ tax return by providing more than 50% of their own support and earning income. Youngsters who do not meet those exceptions must have incomes less than $1,800 to qualify for the 0% rate.

Couples receiving Social Security benefits will have to be careful when executing these strategies. Increasing taxable income through the recognition of long-term capital gains also could make more Social Security benefits subject to income taxes.

In most cases, the additional tax on the Social Security benefits will be quite low and will make the effective tax rate on taking the capital gains just a few percentage points. Even so, one should run the numbers to determine the effect such a transaction would have on the full tax picture.

A taxpayer needs to consider the non-tax picture before plunging ahead to take advantage of the 0% tax rate. There must a reason for selling the asset other than to cash in the gains at a low rate. The difference between the 0% rate and 15% rate is going to be small in actual dollars, especially considering that only the gains below the taxable income thresholds for the lowest brackets qualify for the 0% rate.

Yet, if someone planned to sell the asset in the next few years, needs to reposition a portfolio, or has a new opportunity, taking a look at how to qualify at least part of the gain for the 0% rate is worth doing.

When deciding which assets to sell, one strategy is to sell stocks or other assets with the least amount of capital gains. Normally, with a tax-advantaged strategy one wants to maximize the gains taxed at the low rate. But there is a ceiling on the amount of gain that qualifies for the 0% rate each year. The goal should be to generate the maximum amount of cash at the lowest tax cost. By selling assets with the least appreciation, it is possible to free up more after-tax cash than if assets with higher appreciation were sold. This is a good strategy for retirees who are deciding which assets to sell to pay for their expenses the next few years.

The main problem now for most people will be to find assets that have capital gains in them. But those who have held assets for a long time likely have gains they have not recognized.

The 0% tax rate is tricky. But there are many retirees who qualify for it, and they should review asset sale strategies.

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site www.RetirementWatch.com.

A Tricky Year-End for IRA Owners

Bob Carlson — Fri, 05 Dec 2008 14:15:00 GMT

Update Dec. 19: On Dec. 11 Congress passed legislation that suspended the required minimum distribution requirement for 2009. But it did not change the requirement for 2008. the IRS was asked by members of Congress to suspend the requirement for 2008. But on Dec. 17 it sent a letter to key members of Congress saying it would not do so. An IRS official told the Washington Post that it did not have authority to change the rules. Only Congress could do that. In addition, the IRS could not devise a solution that would be fair to those who took their 2008 RMDs before December.

The financial crisis continues to have secondary effects few people anticipated. Decisions are required now, especially with regard to IRAs. Let's take a look at the key issues in question-and-answer format.

Is there relief for IRA owners over age 70½ who have not yet taken their required minimum distributions for the year?

IRA owners must take required minimum distributions by April 1 off the year after they turn age 70½ and by Dec. 31 of each year after they turn age 70½. The RMD is computed based on the IRA balance as of Dec. 31 of the preceding year. The Dec. 31, 2007, balance is used to determine the 2008 RMD. We discussed details of computing the RMD in the April 2008 visit, and that discussion is available on the web site Archive.

The problem for 2008 is that many IRA balances are far below their 2007 levels. Major stock market indexes are down around 35% to 40% from that date. Some investments declined even more. IRA owners who have not already taken their RMDs for the year are required to take RMDs on wealth that no longer exists.

There is only one limited provision in the tax law to reduce the RMD in this circumstance. The RMD is fulfilled when the amount taken from the IRA brings the balance to zero. That does not help many IRA owners. If taking the RMD does not wipe out all your IRAs, you are required to take the full RMD as calculated using the 2007 balance.

Several proposals were put forth in Congress in 2008 to provide some way of altering the requirement for those whose IRAs declined. None was enacted, but there is a possibility of some action in a special session now taking place. If there is a bailout bill for the auto companies there is a chance a waiver for RMDs will be included. But that is not very helpful, since you have to take your distribution by Dec. 31, and IRA sponsors often get backed up this time of year. If you wait to put your RMD order in, it might not be processed by Dec. 31. IRA owners are in a tough spot on this issue, because waiting to see if Congress acts could mean a distribution won’t be made by the Dec. 31 deadline if Congress does not act.

Can the RMD be avoided by converting the traditional IRA to a Roth IRA?

The original owner of a Roth IRA does not have to take RMDs (though beneficiaries who inherit Roth IRAs do). A traditional IRA can be converted to a Roth IRA when the owner's adjusted gross income is no more than $100,000. There are taxes due on the conversion. The converted amount must be included in gross income as though it were distributed. The converted amount and any RMD for the year do not count in determining the $100,000 limit.

This is a good time to convert a traditional IRA to a Roth IRA, because asset values have declined. You can make the conversion at a much lower cost than a year ago, and the future income and gains will be distributed tax free to you and the IRA beneficiary.

A conversion, however, cannot be used to avoid a current required minimum distribution. If the IRA owner is required to take an RMD for the year, the RMD still must be taken even if there is a conversion and regardless of the date during the year the conversion occurred. The conversion, however, will avoid future RMDs.

If I have to take an RMD this year, which assets should I sell to take it?

A common misconception about RMDs is that an asset has to be sold and then the cash distributed from the IRA. In fact, a distribution of either cash or property meets the requirement, as long as the value of the property on the day of the distribution equals the RMD for the year. Or if several distributions are taken over the year to fulfill the RMD, the aggregate of the property values on the dates of their distributions must at least equal the RMD. You don’t have to sell any assets to take an RMD.

Most IRA custodians also offer taxable accounts. It is a simple procedure to set up a taxable account at the custodian. Then, direct the custodian to transfer property from the IRA at least equal in value to the RMD to the taxable account. The transferred property can be bonds, shares of stock or mutual funds, other securities, or any other property in the IRA. The custodian will determine if some of the property is not transferable.

If the custodian does not offer taxable accounts, set up a taxable account at another financial institution that will accept the assets. Then, have the securities or other assets transferred from the IRA to the new taxable account. This transfer might take more time, so the paperwork has to be started earlier in order to meet the Dec. 31 requirement.

If you do not want to sell assets to fulfill the RMD, you do not have to. Instead, distribute property from the IRA to a taxable account. The value of the property at the time of the distribution will be included in gross income and count as the RMD. The tax basis of the assets will be their value on the date of distribution, the same amount included in gross income. Because of the tax treatment, it makes sense to distribute those assets that have declined the most and are likely to appreciate the most in the future. Once those assets are in a taxable account, future appreciation is likely to be taxed as long-term capital gains. If the assets remained in the IRA, future appreciation would be taxed as ordinary income when distributed. Also, if the assets continue to decline in value after being distributed, the assets can be sold and the loss deducted on the tax return. Losses in an IRA cannot be deducted in most cases.

I need at least part of the RMD in cash to pay expenses. How should I determine which assets to sell and distribute? Those that have declined the most, the least, or some other measure?

One step investors fail to take on a regular basis is to rebalance their portfolios. A portfolio should have a target asset allocation that meets your return goals and risk tolerance. Over time the markets move the portfolio out of balance because the investments will have different rates of return. The portfolio should be rebalanced to bring it back to its original allocation target.

RMDs can be used to rebalance the portfolio. Sell or take distributions of assets in ratios that bring the portfolio to its target allocation. Sell assets that are above or closest to their targets. That is the fastest way to bring the portfolio back to target. Other changes can be made within the IRA to bring it back to your target allocation, such as selling those that have declined the least to buy more of those that are farthest from their targets. You can choose to make sales and distributions in other ways, but recognize that those would be a change in your portfolio strategy.

Another approach is to use tactical asset allocation to choose the RMD assets. For example, you might choose to hold the assets that have held their value best. Or you might hold those that have declined the most, believing they are likely to appreciate the most when things turn around. Either move would be a bet on coming market trends. The first strategy would be an assumption that recent trends will continue. The second move would be based on a belief that we are near a bottom and you want to capture the following rally. There is nothing wrong with either move. Be aware that you would be straying from your initial strategy and effectively making a forecast about the market.

I sold an asset in my IRA to take a distribution. Can I buy that same asset in my taxable account?

This question is a reference to the "wash sale" rules which prevent a taxpayer from selling an asset to deduct a loss but immediately buying the same asset so that the portfolio position has not changed. The wash sale rules say that a loss deduction is deferred if a substantially identical asset is purchased within 30 days before or after the sale. The wash sale rules apply whether the substantially identical asset is purchased in an IRA or taxable account.

Since a loss incurred in an IRA is not deductible, however, the wash sale rules do not discourage or prohibit you from purchasing a substantially identical asset in a taxable account after selling it in an IRA.

What are the rules for making charitable donations directly from an IRA?

For most people, there is no good reason to make a charitable contribution from an IRA. If you do, the amount is treated as a distribution and included in gross income. You can take a charitable contribution deduction for the identical amount. But you must itemize deductions on Schedule A to benefit. In addition, if your income is high enough, the itemized deduction reduction reduces the amount of your charitable contribution. So, you might not have a full offset of the amount included in gross income.

Those who are over age 70½ receive special treatment. This provision was in effect for 2007 only but recently was extended to the end of 2009.

The special treatment is that a charitable contribution can be made directly from the IRA without including it in gross income. There is no offsetting deduction, but there is no gross income either. Only the first $100,000 of charitable contributions from IRAs each year receives this treatment. In addition, the contribution must be made directly from the IRA to the charity. You must direct the IRA custodian to make the transfer or issue a check.

Another bonus is that the donation can count as part of your RMD for the year. You still are required to take the full amount of the RMD based on the 2007 balance. But by giving all or part of the RMD to charity, the amount does not have to be included in gross income.

Your Retirement Plan and the New Washington

Bob Carlson — Fri, 07 Nov 2008 17:44:00 GMT

Come January, Democrats will be in charge all over Washington. They campaigned on a theme of change, and we should expect major changes. The questions are which changes and how will they affect your retirement finances?

I will focus on the changes I think are most likely to occur. When evaluating the prospects for change, it is important to keep in mind the tension that will exist in the New Washington. Congress will be run by very liberal politicians who have a long list of legislation they wanted to pass for many years. These wish lists generally involve higher spending, more government control and regulation, rewarding favored activities and punishing others, and of course higher taxes. The new President, on the other hand, wants to be re-elected and probably recognizes that the country is center-right, not liberal, on most issues. There will be tension between the President and Congress, and the great unknown is which one will prevail. I assume that for at least the first couple of years the President will have the upper hand and will be able to move the more extreme liberal measures to the back burner.

Here are things you should prepare for over the next year or two. Other changes might be coming after that.

Medicare: This health program for those over 65 is approaching bankruptcy. Social Security will begin spending more than it receives in a few years. Medicare passed that point long ago. It soon will have exhausted the “trust fund” set up for it and rapidly is taking a larger share of the federal budget.

A few years ago “means-tested” premiums began as we discussed in Retirement Watch. Premiums increase as a beneficiary’s income rises. Similar changes are likely to occur. Premiums for higher income beneficiaries could rise even more and some types of care might not be covered for higher income beneficiaries. Or deductibles and co-payments also might be means-tested. Higher income beneficiaries might be required to cover the first $5,000 to $10,000 of their medical expenses in addition to paying higher premiums.

The government might have a stronger role in “negotiating” drug prices. Medicare prices are a basis for prices providers charge to private insurers. If the government negotiates very low prices, manufacturers might conclude that some drugs are unprofitable to produce or reduce research spending on new drugs.

The government also might take over the Part D prescription drug program instead of allowing private insurers to compete for beneficiaries.

Medicare Advantage plans also might take a hit. Democrats in Congress have targeted these since returning to the majority after the 2006 election. These plans run by private insurers receive higher reimbursements than other Medicare plans but usually offer greater benefits. Democrats want to eliminate them and bring everyone back into traditional Medicare.

Greater use of technology is likely to be mandated across the medical profession, and the government will assume cost savings from this move. It also is a way of pushing costs from the government to the private sector. That could affect the quality or availability of care for a while and increase costs on care not covered by Medicare.

Estate tax: Congress has to address the estate tax soon. The current law eliminates the estate tax for 2010 and returns to the 2001 law beginning in 2011. Congress is unlikely to let either the expiration or return to 2001 law occur.

The most likely outcome is, after a great deal of debate, something similar to current law will be enacted. That means the estate tax exemption will be fixed at $3.5 million and might be indexed for inflation. The top estate and gift tax rate will be 45% or 46%, though it could go up to 50%. It will be interesting to see if the lifetime gift tax exemption remains capped at $1 million or is allowed to rise. Also unclear is whether the current step-up in basis that is allowed for inherited assets will continue or whether heirs will have to take the deceased’s basis and pay capital gains taxes on appreciated that occurred during the deceased’s ownership.

Retirement plans: Here is a sleeper issue that came up only in the last month. Many in Congress do not like President Bush’s “ownership society” concept, and they view 401(k) plans as part of that. They are looking at ways to change qualified retirement plans.

A longstanding goal was to require private employers to provide minimum pensions. That might be replaced by a plan to have the government take over private pensions. Recent committee hearings highlighted a plan that eventually would eliminate tax breaks for 401(k) plans and give individuals a window during which they would receive some benefits for converting their private 401(k) plans into government retirement plans. This approach clearly has support from congressional leaders, but its support beyond that is unclear.

Investing: Anticipate some surprises here. Presidents are not able to implement all their campaign proposals. Congress and circumstances can change the plans. Don’t invest based on campaign rhetoric. Wait until proposals are closer to becoming laws.

There could be a positive surprise in the change of power. The financial problems largely have developed into a confidence problem. People do not trust current leadership or the information it puts out. Financial companies do not know what to expect from the government, so they are hoarding cash to protect themselves. Investors simply are not buying anything with risk, and financial firms are not doing business.

Some shrewd moves by the new President in the next few weeks could start to restore confidence at least temporarily. Appointment of a popular choice for Treasury Secretary and announcement of an effective tax cut and regulatory reform plan could spur optimism among investors.

Of course, stumbles on any or all of these issues could extend the crisis. Further down the road, higher taxes, spending, and regulation could reverse any positive trends. But there is an opportunity now to restore optimism even as the economic slump deepens for the next quarter or so.

Congress also could squander the opportunity. There is a movement to expand the government rescue plan to include a range of industries and to impose very tight regulations on financial and other firms taking government money that effectively nationalizes them. A move in that direction would further diminish investor confidence.

Don’t believe simple analyses of how the new administration will affect investments. It is normal for analysts to look at campaign proposals and target companies they believe will benefit from the proposals. Those forecasts almost never work out. Ignore analysts who recommend that you buy “green companies” and short defense contractors and health care companies. Wait for detailed plans to be proposed and make their way through Congress.

Taking action simply on the new election of politicians can be a risky business. I have outlined what I think are the most likely changes over the next few years. But be prepared for surprises. You need to build a cash cushion in your retirement plan for the possibility of paying a higher share of medical expenses. Be ready to revise your estate plan sometime next year or early in 2010. Keep an eye out for early signs of changes in retirement plans and be ready to move your assets into other types of accounts in case a major change is in the works. With your portfolio, don’t fall for obvious analysis. There is the potential for surprise in the next few weeks.

Why Most Retirement Investment Plans Are Wrong—Part I

Bob Carlson — Fri, 24 Oct 2008 17:58:00 GMT

The current financial crisis and market panic demonstrate why most of the investment plans for those in or near retirement are wrong. There are better ways to manage retirement money, but you will not learn about them from conventional advisors and sources.

Most retirement investment plans generally use one of three general strategies. Each of these strategies is flawed and puts retirement goals in danger. In this posting we will look into these strategies and why they are inappropriate. You can find more details in my book, Invest Like a Fox…Not Like a Hedgehog.

Traditional Investing

One strategy is to shift the portfolio from equities to bonds as one nears retirement. The idea is that an older person cannot take much of the risk in the equities markets, so should be in stable, income-producing bonds. A standard formula is to subtract your age from 100 and let that be the non-bond allocation of your portfolio.

One problem with this approach is inflation. Because people are living longer, their income needs to increase over time to maintain the same standard of living. Otherwise, even modest inflation will significantly reduce the purchasing power of bond income by 20% over five years and by half over 24 years. Two percent inflation reduces purchasing power by 20% after 10 years. Another way to look at the problem is that after 10 years of 3% inflation, a retiree needs 130% of the first year’s income to maintain purchasing power.

With longevity increasing, inflation is a major consideration. The average 65 year old man who retires today has about a 20-year life expectancy—and that means half today’s retirees should plan to live longer than another 20 years.

To combat inflation, a portfolio needs a growth component that will produce adequate growth for the future while providing enough income to meet current expenses.

Other problems with the income portfolio have become very obvious since the summer of 2007.

Yields on bonds and income-oriented stocks can sink to low levels. The yields might not be enough to generate adequate income unless the portfolio is quite valuable. Yields on safe treasury bonds are at or near historic lows, and the financial panic caused a flight to safety that pushed short-term treasury yields below the inflation rate. The disinflation that began in1982 pushed treasury yields from generous double digit levels to today’s inadequate yields. I regularly hear from investors who purchased certificates of deposit or treasury bonds years ago. When those investments mature, the investor has to reinvest the principal and will receive much lower yields if reinvesting in the same vehicles.

You could venture out of treasuries and CDs into higher-yielding alternatives such as investment grade or high-yield corporate bonds, preferred stock, emerging market bonds, and other alternatives. Unfortunately, these investments carry additional risks, and those risks can be much higher than for treasuries, especially during a recession or financial panic. The risk can be as serious as the bond issuer’s going bankrupt and the bond’s becoming worthless. Lesser risks are that the bonds lose favor with investors and their values decline. If the investor buys bonds directly (and not through a mutual fund) and holds them to maturity, sinking market values are not a problem as long as the issuer makes the income payments and repays the principal at maturity. But market prices are a problem when investments are through funds or the investor does not want to be locked in to holding until maturity.

Many investors cannot tolerate these risks. The income for retirement investment strategy was developed when the average retirement lasted five years. Today, the average retirement lasts 20 years or longer, and a different strategy is needed.

Modern Portfolio Strategies

A second investment approach, which has been used by most investors in recent years, is to buy and hold a diversified portfolio of investments. This strategy is based on academic work known as the efficient market theory and capital asset pricing model. This strategy is easy to implement using today’s technology, and most portfolios developed by investment professionals use it.

Implementing the strategy is fairly simple. You determine the level of risk you are willing to take and the rate of return you need. The software develops an “efficient frontier” that shows portfolios that generate the highest return for a given level of risk or the lowest level of risk for a given return. Investors select the portfolio with the risk-return combination they want and are told that while returns will vary from year to year, over time they are likely to achieve their return goals while taking the level of risk acceptable to them.

This strategy has significant problems, especially as it is usually is executed.

The risk and return trade off for different investments often is determined using historic data. Unfortunately, the markets change over time. Historic returns and risks do not determine future returns. One would think at least sophisticated investors would have learned that after the collapse of Long-Term Capital Management in 1998 in the last great liquidity crisis. Even so, Alan Greenspan admitted in his recent testimony to Congress about the financial crisis that professional investors used flawed models to evaluate the risk in their portfolios. They used only 20 years of data, which did not show what would happen in a crisis.

Likewise, the portfolio is supposed to be diversified by holding investments that have low correlations with each other. When part of the portfolio is down, other parts of the portfolio should be up. That prevents wide swings in the portfolio’s value from year to year though individual markets will have volatile prices. But correlations between investments change over time. Sometimes the changes are permanent; other times the changes are temporary. One adage among some investors is that diversification works until you need it most.

We saw that adage at work in most major market declines, including the one in September and October 2008. Virtually all investments except treasury bills declined. Even gold, a usual haven in a crisis, suffered. The only benefit of diversification in the panic was that some assets declined less than others.

Another problem with the CAPM approach is it treats volatility as risk. To most investors, volatility is not risk. Risk is the probability investment goals will not be reached, such as running out of money during retirement.

An even more important problem is returns over shorter periods differ from long-term averages. When long-term returns are presented as a list of numbers, one can have the impression they are earned more or less steadily. Examining a long-term chart of how the average was developed or computing returns for shorter periods paints a different picture. Returns can lag the long-term average by significant amounts and for significant periods.

A foundation or other institutional investor might be able to invest for the long-term using 70 or more years of market data. Individual investors, however, are not able to invest with a 70-year time frame that ignores return patterns over shorter periods. To most investors, returns over the next 10 years are what matters. An investment plan can fail if returns for the first 10 years are significantly below the long-term averages.

There are extended periods when returns are below the long-term average. From 1998 to the present is one such period. If one retires early in such a period and begins taking withdrawals based on long-term returns, the retirement portfolio is likely to run out of money before a new bull market can restore the portfolio. The long-term average return is a myth. There are very few years, much less extended periods, when markets return the long-term average. With U.S. stock indexes, the return in any year usually is significantly above or below the average.

The advice under CAPM is to develop a portfolio that over the long term provides the trade off between risk and return the investor seeks. Then, hold that portfolio allocation. Most followers of CAPM recommend investing only through index funds and similar passive investments. Over time, as markets perform as they have in the past, the investor will achieve his goals.

We have seen that is not the case over periods less than the long term. Asset classes can change their correlations, and that increases the risk in the portfolio. More importantly, asset classes have long-term bull and bear markets. They can underperform their long-term average not only in the short-term but for extended periods. Stocks and commodities earn less than their historic averages for periods of 10 to 20 years. Such extended periods of underperformance can be devastating to investors who do not have a 70-year time frame.

During these periods, a return that matches or beats an index is not useful to an investor. The investor wants assets in the portfolio that have no correlation with the major indexes and whose returns are not tied to the return patterns of the indexes.

The efficient market theory and investment strategies built upon it do not serve investors well, because they are flawed in theory and as practiced. Here are some key questions that are not answered by modern investment theory:

Why do long-term bull and bear markets occur? Under efficient market theory, they should not occur.

Why are prices of investments more volatile than the underlying fundamentals?

Why do stock prices change without a change in fundamentals or without a change in fundamentals of the same magnitude as the price change?

Why does the equity risk premium exist? If markets are as efficient as in the theory, stocks should not generate higher long-term returns than other investments.

Because these questions are not answered, the strategy produces flawed portfolios.

Adventures in Timing

The third strategy in common use is to change the portfolio based on market or economic signals. As we will see in the next posting, changing the portfolio to reflect fundamental changes is a good strategy. But too many investors use the wrong standard to make changes.

Many investors seek one or a small number of data points for guidance on when to make portfolio changes. They conduct a great deal of research to find correlations between changes in data and subsequent changes in an investment, an exercise known as data-mining.

The problem with this method is that the value of an indicator declines over time. Once-reliable indicators fail to generate the same results. Indicators that once were considered reliable but failed in recent years include the dividend yield, price to book value, price-earnings ratio, and q ratio. Technical analysis also has a spotty record. Some investors use data external to the market, such as interest rates and federal budget deficits, but these also are not reliable.

Data-mining fails to produce useful investment tools for several reasons:

The exercise confuses random events with causation. My favorite example of this comes from David Leinweber who wrote a paper for First Quadrant, an investment management firm, in 1997. Leinweber took a CD-ROM of data from the United Nations that contained detailed economic data from most countries in the world. He ran the data through computer programs to find the best predictor of the S&P 500. He concluded that the data with the closest correlation to that index is butter production in Bangladesh. He titled his paper, Stupid Data Mining Tricks.

As protection against such results, a piece of data should be used to make investment decisions only if a reliable theory can explain why it works. Otherwise, the correlation between the data and the markets is a coincidence and not cause and effect.

Even when a correlation is found, it never is a 100% correlation. There are times when the cause and effect do not both occur. Before putting his capital at risk, the investor has to be confident this will not be one of the outlier times or that the potential loss will not be too severe.

There are too many variables affecting a market to be able to capture the meaningful ones in a manageable amount of data.

Markets are dynamic. Markets are human beings acting together. People learn, or at least they change their behavior over time. A condition that produced a certain reaction in the past might not produce the same reaction today and probably won’t five or 10 years from now.

Beginning and end points affect the results of data mining. There are many examples of researchers who found a correlation between a market and certain data in a particular time period. Other researchers who explored the relationship over different time periods either did not find the correlation or found a much weaker correlation.

Another problem with both CAPM and using data to make portfolio changes is that markets have fat tails. This is a statistical term. A normal distribution of results has thin tails. That means extreme results occur very rarely. In the investment markets extreme results, both good and bad, happen with much greater frequency than under a normal distribution.

Fat tails have several effects. One effect is that a few extremely positive periods can make the long-term average return high. In fact, only investors who were invested during those few brief periods earned positive returns. Negative fat tails can have such high negative returns that they wipe out not only recent positive returns but also part of the investor’s capital. An investor who enters an investment with negative fat tails at the wrong time could lose all or most of his capital and not gain the benefit of the positive fat tails.

A timing tool that has good long-term average results but that has fat tails might have achieved those results based on one or a few good periods while underachieving most of the time.

Turning points are obvious only in hindsight. It is easy to look at long-term data and identify the turning points. It is much harder to be in a fast-moving market in real time and identify today’s confluence of events as a turning point. In the bull market of the 1990s many investors exited the markets several years before the peak. Their historic indicators showed the turning point was reached long before it actually was. In the 2007-2008 decline many investors re-entered the markets early, believing a bottom had been reached. To use price-earnings ratio as an example, only after the fact can one determine whether the low price-earnings ratio for the cycle was 16, 13, or lower.

Another reason to be wary of data as market indicators is that once an indicator is well-known, it stops working. Since investors learn, the knowledge of a correlation between the markets and some other data tends to alter behavior.

Most investors think like hedgehogs, as characterized by poet Archilochus in 7^th century B.C. He wrote, “The fox knows many things but the hedgehog knows one big thing.” Investors want to learn one big thing and hold on to that. That is the downfall of many investors. Markets are dynamic. They are dynamic because markets are people acting together and people change and learn over time. Markets also are dynamic because the legal, economic, and financial structures of the markets change. Investors have to recognize the changes and be able to adjust their strategies.

An investor who thinks like a hedgehog can be successful if his prime investment years coincide with a market period that matches his “one big thing” insight. For example, an index fund investor did quite well from 1982 through 2000 but less well since then. A treasury bond investor did well during the same period, earning high yields and capital gains. Today, a treasury bond investor earns low yields and might see the bonds lose value as rates rise in the coming years.

A long time successful investor needs to think like a fox. The fox, as characterized by Archilochus and later by philosopher Isaiah Berlin, pursues many ends and thinks and acts on many levels. The fox uses many experiences to inform his beliefs and does not try to fit all experiences into one all-compassing principle. Instead, the fox is eclectic and even inconsistent. The fox is wary of big, central principles and simple historical analogies. Most importantly, the fox adapts and adjusts with conditions.

In the next posting we will learn how an investor can think like a fox to improve investment returns and how to develop a retirement investment strategy that is more likely to achieve its goals and reduce risks.

Finding Higher Returns with Low Risks

Bob Carlson — Tue, 07 Oct 2008 23:22:00 GMT

Market volatility and uncertainty spur the search for investment alternatives. Index fund investors broke even or lost money the last 10 years, depending on what the markets did in the latest volatile week. The index fund investors did worse than simply owning treasury bills or a money market fund. Investors need their portfolios to grow after inflation and taxes if they are to meet retirement goals, but many investors want to avoid the risks and volatility of traditional growth assets such as stocks.

Investors seeking growth with lower risk and volatility can turn to "structured products" such as equity-indexed annuities. EIAs offered by insurers are the big sellers, but banks and other financial institutions offer similar investments. These can be good additions to the portfolios of some investors—if they understand the details and costs of the products and their limits.

An EIA first promises safety of principal and often a guaranteed minimum return of 1% to 3% annually, depending on the insurer and current interest rates. An EIA also offers the potential for a higher return based on a stock market index. The account will receive the stock-based return when the index has positive returns but will not share losses when the indexes decline. Because of the guarantee the account can earn a positive return when stocks lose money.

Here are the key provisions to understand when considering an EIA or similar structured investment. Understanding these points ensures you understand the investment and will not be surprised by results over the years if you choose to buy it.

Index. The insurer determines the index used to determine the account’s returns. The index is stated in the contract, but in most EIAs the index can be changed. Shortly you will see that the insurer does not pay the return of the index but a return based on a formula that is based on the index’s return.

Participation rate. Some EIAs credit the policy owner with the full return for the year as determined by the return formula; others have a ceiling participation rate. For example, the credited return might be 75% of the return computed under the formula.

Return ceiling. An additional way of limiting the return in EIAs is an explicit limit on one year’s return. Ceilings generally are 7% to 10%. For example, an EIA might say the account earns 75% of the return under the formula, up to a maximum return of 8% each year.

Return formula. The annuity is not invested in stocks, and the investor is not earning stock returns. The account is credited with interest, and the amount of interest is based on stock market returns. The combination of the index’s returns and the return formula determine the interest credited. There are over 30 different formulas used for computing interest for EIAs. Many investors assume that an index's return for the year will be credited to their accounts. That point-to-point valuation is rare. Most EIAs use some kind of averaging method. Because stock returns for a year tend to be bunched in a few days, credited returns under the formulas can be far less than the index's return for the year. Here are a couple of examples of formulas.

Averaging. Under this method, the ending values of the index for each period used in the formula (usually days or months) are added. The total is divided by the number of periods. The difference between the index's beginning value and the average value is the return for the year. Insurance analysts estimate that in a bull market, this method credits the account with about half of the index's actual gains.

The averaging method tends to be offered with higher annual caps and participation rates. It also reduces the damage from funding an account a few days before a major market drop. Also, if the index rose for much of the year but suffered a major decline near the end, the averaging method credits those early gains.

Point to Point. This is the method most people assume is used. The difference between the beginning and ending values of the index over the period are used to credit the account. Point to Point likely will give a higher return in a bull market than the other methods, but it exposes the owner to more risk in a declining market and also higher volatility than the other methods. It also is likely to be accompanied by lower caps, participation rates, and other limits than some of the other methods.

The EIA also might contain a couple of protections that prevent a bear market from severely restricting interest credited to the account.

Annual Reset. The annual reset method prevents bad years from taking away gains. The gains from one year establish a new account floor. Future losses cannot bring the account value below that level.

Suppose Max Profits put $100,000 into an EIA. After five years, the account value is $150,000. The sixth year the index declines 10%. The account value still is $150,000 at the end of the sixth year.

The annuity owner might be able to select the reset period. An annual reset method can be good in trading range markets but likely will be accompanied by lower annual caps on returns and lower participation rates.

High Water Look Back. This method is being offered more frequently. It provides that the account value credited at the end of the contract will be the highest of the values on the contract’s anniversary dates. For example, suppose an EIA is owned for 10 years. The index rose steadily during the first nine years, giving a rising account value. The index tumbles the last year. When the contract is terminated, the account is credited with the value on the second-to-last anniversary date instead of the lower value on the last anniversary date. Note that the credited value is not the highest value during the 10 years but the highest on the anniversary dates.

Investors also should look at two other key points in the formula. Some formulas look at only changes in the index value and do not count dividends paid during the year. Also, some measure returns over the years as simple interest instead of compound interest.

Tradeoffs. The return formula, participation rate, and return ceiling need to be considered together. Generally, insurers make trade offs between the three. EIAs with less than 100% participation and with restrictive valuation formulas tend to have higher return ceilings of 10% or so. Typically an EIA that allows 100% participation will have an annual return ceiling of 7% to 8%. If an insurer or broker is focusing on one of the features, be sure to study the others.

The trade offs require some consideration. The combination that intuitively seems the most attractive often isn't. Suppose the index returns 10% one year. One EIA has 100% participation rate but a 7% cap. That EIA's investors get credited with a 7% return. Another EIA has 75% participation rate but a 10% cap. Those investors get 7.5% credited to their accounts for the year.

Based on past market return patterns, an investor is likely to earn a higher return over time with a higher cap and a lower participation rate. That's because an index's returns each year tend to be far from the averages. Good years in the market tend to be very good years. If this pattern of returns continues in the future, the lower participation rate/higher cap EIA is likely to be the better choice.

Some EIAs also have multi-year caps. For example, a policy might say that the return over two years will not exceed 15%, regardless of any other policy provisions.

Fees. After the return for the year is calculated, fees are subtracted and the net-of-fees return is credited to the account. Most EIAs charge fees only when returns are positive. But the more generous the EIA's policy of crediting returns is, the higher the fees tend to be. An EIA with 100% participation and a high or no ceiling likely will have annual fees of 2% or more. That could be great if the index returns 20%. But when the market returns 10% or less, an EIA with a less generous crediting policy and lower fees would generate a higher net return.

Again, it pays to look at the interplay of fees, ceilings, valuation formulas, and participation rates under different return patterns. A period of steady, low returns would favor an EIA with low fees. A pattern of widely varying returns with the positive returns above 10% would be rewarded by 100% participation and no ceiling with higher fees.

Many EIAs allow fees and charges to be changed, and the maximum fees that can be imposed are quite high. Be sure to ask what current policy holders are charged. Also check surrender charges and minimum holding periods. The EIAs with the most attractive initial terms tend to be those with the highest penalties for withdrawing from the EIA.

Changes. Most EIAs retain the right to change any of these provisions. There might be a limit to the potential amendments, but the insurer can review the terms each year. A 100% participation rate can become 75%, or a 10% cap could decline to 8%. There's not much the policy holder can do except realize terms that are more attractive than those on other EIAs can change at any time.

Commissions. Most EIAs offer the selling agent or broker generous commissions of 5% to 9%. The higher commissions usually are on policies with high surrender charges or more restrictive terms. The commissions usually are paid directly by the insurance company.

Investment bonuses. Some EIAs offer bonuses. For example, an EIA might credit an extra 10% to the policy holder's account for purchasing the annuity. Or 1% annually might be credited for each year the policy is owned. Such bonuses almost always come with higher surrender charges, longer required holding periods, and other restrictions.

Withdrawal phase. An EIA usually imposes a surrender charge if the investor withdraws all or some of the money before a minimum period has passed. An investor should know the surrender charge and surrender period before investing. An investor who is sure the money will not be needed for seven years or more often can find an annuity with generous terms that has a long "lock up" period or a high surrender charge. Other investors want a minimal surrender period and low charge in case their cash or investment needs change.

Also, even after the lock up period has passed, some annuities do not allow the investor to withdraw the account in a lump sum. They might require annuitization—a stream of fixed for life payments from the insurer. Others allow only a maximum amount of 10% or so to be withdrawn in any one year. Most EIAs, however, allow the entire account to be withdrawn or rolled over to another annuity. Don't be dazzled by generous front-end terms that are taken away by limits on how money can be withdrawn.

Insurer safety. The only guarantee behind the annuity is the promise of the insurer to make the payments. Dealing with one or more insurers that have been around a long time and are in strong financial condition is important.

An EIA is neither a stock market investment nor a traditional fixed annuity. It can be appropriate for someone who wants something more conservative than the stock market but wants to try for higher returns than are available from interest-based vehicles such as fixed annuities, bonds, and certificates of deposit. The returns of an EIA will vary considerably from year to year. The good news is that, unlike a stock market investment, the return any year will not be less than zero in most EIAs. On the other hand, an investor won't know until after the year what, if anything, the return for the year is. In addition, in years of strong stock market returns, the investor likely will be credited with a fraction of those returns.

A potential EIA investor needs to review different EIAs, study the contract terms, and understand the trade offs. Different EIAs are appropriate to different types of investors, and many investors will find all EIAs to be inappropriate for them. Also compare an EIA to a diversified portfolio of low fee mutual funds or to a balanced fund.

Avoiding IRA Inheritance Disasters

Bob Carlson — Fri, 19 Sep 2008 17:31:00 GMT

IRAs are supposed to be simple, but when it comes to inheritance IRAs are more complicated than most people realize. It is not unusual for IRA heirs to misunderstand some key rules. A wrong move or two triggers high taxes, often causing most of the IRA to end up with the IRS. Income taxes can take 35% or more of the IRA. Estate taxes can take another chunk.

Part of your estate planning should ensure that your heirs know what to do — and what not to do — with the IRA. Don't expect that they will get good advice from the IRA custodian, or just any accountant, or financial professional. We are in the early stages of the first generation to inherit IRAs, and many advisors are not up to speed on the rules. IRA custodians are not in the business of advising beneficiaries or their best moves. You need to get good advice and pass it on to your heirs.

Here are the key inherited IRA mistakes and how to avoid them.

Disappearing documents. Your will or living trust has no effect on an IRA. Only the beneficiary designation on the form held by the IRA custodian determines who inherits the IRA. IRA owners often make the mistake of not designating a beneficiary or not updating the form after a beneficiary passes away. Another common mistake is the heirs’ misplacing or not being able to find the designation form. They have to depend on the custodian to have a current copy. Custodians don’t always have a copy, especially if it was filed many years ago or the original firm has merged one or more times.

In any of those cases, the custodian's rules (if it has any) determine the beneficiary. It might be your estate, which is the worst result from a tax standpoint. Or it might be a spouse when you intended the IRA to go to your children.

Keep copies of your beneficiary designation forms in a file that is easy to find, and keep the designations up to date. Let your executor and heirs know where the forms are.

Ignoring spousal benefits. When a surviving spouse inherits an IRA, a special option is allowed.

One option is for the inheriting spouse to treat the IRA the same as any other beneficiary can. Or the spouse can roll over the inherited IRA into a new IRA in his or her own name. The rollover allows the surviving spouse to start a new required minimum distribution schedule based on his or her own age. It also allows the spouse to name new beneficiaries.

The rollover often allows the IRA to last longer both during the spouse's lifetime and when his or her beneficiaries inherit the IRA. Without the rollover, required distributions must begin soon after the IRA is inherited and might use a shorter distribution schedule than the spouse could establish under a rollover.

If the inheriting spouse is under age 59½, however, and needs to begin taking withdrawals from the IRA, then a rollover would not be a good idea. Distributions before age 59½ would be subject to a 10% penalty in addition to income taxes. But the 10% penalty does not apply when the RMDs come from an inherited IRA that is not rolled over.

Your spouse should know that he or she has options, and the consequences can be very different. Ensure that a good advisor is available to your spouse or leave some suggestions and guidelines for the spouse to follow.

Rolling over an IRA or changing the title. Non-spouse beneficiaries don't have the same options as surviving spouses. For example, if your children inherit the IRA and roll it over into their own IRAs, then the entire inherited IRA would be fully taxable. The children would be treated as though the inherited IRA were distributed directly to them in cash. They might also owe a 6% excess contribution penalty for each year the money sits in their IRAs. If they roll over the inherited IRA to new, separate IRAs in their own names, they will owe only the income taxes.

Yet, many IRA custodians simply ask the heirs what they want to do with the IRA and don’t explain fully the consequences of the actions.

To prevent immediate taxation, an inherited IRA must be maintained, but it must be retitled by Sept. 30 of the year after the year of the original owner's death. The new title must have the name of the deceased followed by "deceased" or "decedent." Also included must be the beneficiary’s name and statements that the account is "for the benefit of" or "FBO" of the beneficiary and that it still is an IRA. For example: Max Profits, deceased, IRA FBO Hi Profits, beneficiary.

Spending down the IRA. Despite all their parents' planning, an extremely high percentage of nonspouses who inherit IRAs take the balances as lump sums and spend them. That's too bad. The heirs will pay income taxes on the entire balances. The amount they have left to spend depends on their income tax brackets and your estate tax bracket. In most cases, it is a fraction of the IRA’s original value.

Instead of spending the IRA on whatever their current needs are, heirs should let the IRA continue to compound tax deferred. They would end up with significantly more wealth than they would by taking a distribution. It probably even makes sense for the heirs to suspend their own 401(k) and IRA contributions or other savings to free their own cash instead of taking distributions from the IRA.

If your beneficiaries are likely to spend the entire IRA after inheriting, consider leaving them other property if you have it. It would be better to leave the IRA to other beneficiaries or charity. Heirs that plan to spend the inheritance quickly are better off receiving non-IRA assets, if that option is available to you.

Inheritors of IRAs who do not spend the balance right away must begin taking required minimum distributions over their life expectancies. The RMDs have to begin by Dec. 31 of the year following the year of the previous owner's death.

Some heirs fail to begin taking the RMDs, so they pay penalties. Others take the RMDs under the wrong schedule and take larger distributions than they need to. Be sure your heirs who will not spend the IRAs have good information about how to determine the RMDs that will stretch the IRA the most.

Overlooking the tax deduction. Distributions from an inherited IRA are what the tax code calls income in respect of a decedent. This status entitles the recipient to an income tax deduction for the portion of the estate tax attributable to the IRA. Determining the deduction can be complicated. First, determine the amount of the estate tax paid that is attributable to the IRA. Then, the duration of the IRA distributions is estimated. Finally, a pro rata portion of the tax is deducted each year that a distribution is taken. Details are in IRS Publication 3920.

Not splitting the IRA. Until 2001 and 2002 changes, when multiple beneficiaries inherited an IRA most of the time they had to share the IRA. That meant making joint investment decisions and computing required distributions based on the age of the oldest beneficiary.

Now, an inherited IRA can be split into separate IRAs for each of the beneficiaries. Then, each beneficiary makes individual investment decisions and takes required distributions based on his or her own life expectancy.

If splitting an IRA is what your heirs are likely to do, then check with your IRA custodian. Though the tax law allows IRAs to be split, the custodian doesn’t have to allow it. Be sure the custodian will allow a split and will not charge fees or penalties for the split. If it won’t, move the IRA to another custodian now.

Also, be sure your heirs know their options, the consequences, and the deadlines.

IRAs are the prime assets in many estates. They are surprisingly complicated financial accounts — especially when it is time to take distributions. Few people know how to handle them. Be sure your beneficiaries have the information they need to make the right decisions.

Little-Known IRA Tax Saver

Bob Carlson — Fri, 15 Aug 2008 00:22:00 GMT

Many people own shares of employer stock through 401(k) or other retirement plans. Few of these workers, or many of their financial advisers, know the tax break that is available slash the tax burden from selling those shares. With a little planning and by following a few steps, workers can substantially reduce the tax burden on selling the employer stock and increase their after-tax retirement funds.

The tax break is known as net unrealized appreciation or NUA. The rules work like as follows.

If you sell the employer stock while it is in your 401(k) or other retirement account, you do not receive any tax breaks other than deferral. The proceeds from that sale eventually will be distributed to you (from either the 401(k) or an IRA rollover) and be taxed at ordinary income rates.

To maximize tax breaks, you do not want to sell employer stock while it is in your 401(k). There might be non-tax reasons for selling the stock. If you have doubts about the long-term future for the stock or believe too much of your net worth is in the stock, you might want to sell some or all of it. Otherwise, the shrewd tax strategy is to hold the employer stock while it is in the retirement account.

To qualify for the tax break, you also cannot take any withdrawals from the retirement plan before taking a distribution of the stock, even required minimum distributions after age 70½. If you do, you are ineligible for the tax break.

That is what not to do. Here is what to do to grab the tax break when you retire or otherwise leave the employer.

1. Take a lump sum distribution from the 401(k) plan. This means that all of the account must be withdrawn in the same calendar year. The rule is firm. The entire account must be withdrawn within the same year. It does not have to be distributed at once, but the full account must be distributed within the same tax year. Technicalities can cause people to violate this rule. Start the distribution process early in the year and be sure it is completed by December 31.

2. Have the employer stock deposited in a taxable brokerage account in your name.

3. It usually is best to have the other assets rolled over to an IRA. The IRA rollover means that those assets are not taxed until they are withdrawn from the IRA.

If you follow these rules, the employer stock receives special tax treatment. You include in gross income in the year of the lump sum distribution only the original value or cost basis of the shares. No other taxes are due at that time, no matter how much the shares appreciated since you acquired them.

As you sell the employer shares, long-term capital gains taxes are due on the appreciation that occurred since you acquired the shares. The long-term gain treatment is allowed regardless of how long the shares have been owned either inside or outside of the 401(k).

The treatment is the same whether you purchased the shares through your 401(k) or other employer plan or received them as a matching contribution from the employer.

Suppose you treat the employer stock the same as your other IRA assets and roll it over to the IRA or keep it in the 401(k) until it is distributed to you. Then, the value of the stock is taxed as ordinary income when distributed to you—just the same as your other IRA or 401(k) assets.

The tax break is available even if the company's stock is not publicly-traded. Many private companies periodically determine a value for their stock. These values can be used to determine the employee's basis in the stock. When the employer stock is distributed to you, the employer should tell you its basis.

The NUA treatment also is available to heirs who inherit the 401(k) account and take a lump sum distribution after the employee's death. It also is available to divorced spouses if they received part of the retirement account under a qualified domestic relations order.

An employee does not have to use the NUA treatment for all the stock in the plan. Shares that have appreciated a lot can be distributed to the brokerage account and taxes paid today only on the basis paid. Shares that have not appreciated much can be rolled over to an IRA with other account assets; taxes on those shares are deferred until the shares are distributed.

If a person holds the shares until death, the heirs do not get to increase the tax basis of the shares. The heirs will owe capital gains on the appreciation when they sell the shares just as the employee would have.

The 10% early distribution penalty applies to distributions of employer shares taken as part of an NUA distribution. If the employee is at least age 55 and takes the distribution after separating from the employer, the 10% penalty usually does not apply.