Personal Finance Articles

Taxes could soon take a bigger chunk out of your money – meaning now may be a good time to make the most of tax-advantaged investments in your retirement planning process.

The Bush administration tax cuts are scheduled to expire at the end of 2010 – and when they do, the maximum rate on ordinary income will rise from 35% to 39.6%, on long-term capital gains from 15% to 20%, and on dividends from 15% to 39.6%.

Additionally, in 2013, high-income households will have to pay more Medicare tax on wages and may also face a 3.8% Medicare levy on net investment income, thanks to healthcare reform.

While it’s possible that Congress will postpone the expiration of the Bush administration tax cuts, it’s still a good idea to plan for it and other rate hikes.

So, assuming you’re already maxing out your 401(k) plan contributions, what other steps can you take to make the most of tax-advantaged investments in your retirement planning process?

You may be able to contribute as much as $5,000 a year (plus an extra $1,000 if you’re 50 or older) to a traditional Individual Retirement Account (IRA) or Roth IRA.

If you don’t qualify for such an IRA, you can still put money in a Roth IRA indirectly by opening a non-deductible IRA (which anyone under age 70½ with earned income can do) and then convert it into a Roth IRA. If you have self-employment income, you may be able to put money in a SEP IRA or solo 401(k), which allows contributions of up to $49,000 this year (with an extra $5,000 for the solo 401(k) if you’re 50 or older).

The legal and tax information contained in this article is merely a summary of our understanding and interpretation of some current provisions of tax law and is not exhaustive. Consult your legal or tax counsel for advice and information concerning your particular circumstances. Neither we nor our representatives, may give legal or tax advice.

You’ve likely heard the old adage about sticking to high-quality stocks.

But what exactly are high-quality stocks?

When investment professionals refer to high-quality stocks, they’re referring to those of companies that have proven their ability to deliver strong and steady results over the long term. Following are three ways to spot such companies:

High ROE: Earnings don’t tell you how a company’s doing, but return on investment (ROE) does. ROE measures how much profit a company has earned relative to what shareholders have invested. For example, if a company generated a net income of $13 billion over a one-year period and shareholders invested $63 billion in the company, its ROE would be 20%. Companies with ROEs of 15% or higher are considered very efficient.

Steady Dividends: Companies that routinely pay generous dividends are clearly generating a healthy cash flow. But companies don’t necessarily have to pay high dividends to be strong. They just have to have enough general cash flow to be able to pay dividends if they want to. This is sometimes the case with technology companies.

Good Growth Prospects: High-quality stocks tend to have competitive advantages that can keep rivals at bay – and those advantages aren’t always clear. A fast-food chain may not seem to have an advantage, given that there’s a fast-food chain on just about every corner, but if the company has significant real estate holdings, the picture may change.

Many investors fail to take advantage of the opportunity to make catch-up contributions to retirement accounts -which may not be a good idea, as they can make a significant difference in retirement wealth.

Investors age 50 or older as of year-end can make catch-up contributions to 401(k), 403(b) and 457 plans as well as traditional and Roth IRAs.

Maximum catch-up contributions for the 2010 tax year are $5,500 for 401(k), 403(b) and 457 plans and $1,000 for IRAs.

How much extra could you accumulate by making catch-up contributions? Quite a bit.

Let’s say you turn 50 in 2010 and contribute an extra $5,500 to your 401(k) plan for 2010 and the next 15 years, until you reach age 65. At a 4% annual return, you’d end up with an extra $120,000.

At a 6% annual return, you’d end up with an extra $141,000. And with an 8% annual return, you’d end up with an extra $167,000, according to The Wall Street Journal.

Additionally, let’s say you turn 50 in 2010 and contribute an extra $1,000 to your IRA for 2010 and the next 15 years, until you reach age 65. At a 4% annual return, you’d end up with an extra $22,000.

At a 6% annual return, you’d end up with an extra $26,000. And with an 8% annual return, you’d end up with an extra $30,000, also according to The Wall Street Journal.

Married? If your spouse can make catch-up contributions as well, you could potentially double the amounts shown here as a couple.

As you can see, making catch-up contributions can potentially add up by the time you reach retirement age – so they’re worth considering.

Of course, these examples are hypothetical and are not intended to represent any particular product. Contact your financial advisor to determine how much you could accumulate with catch-up contributions.

Bondholders may have seen their portfolios come through the recent market turmoil in fairly good shape; however, they may not want to assume that performance will continue, due to the prospects for inflation and interest rate increases.

The U.S. government reacted to the financial crisis of 2008 and 2009 by pumping an unprecedented amount of money into the economy – two packages of fiscal stimulus totaling more than $1 trillion, according to Stimulus.org. That stimulus could cause inflation to rise.

The government has also kept interest rates near all-time lows in order to stimulate consumer spending. But many economists think rates are poised to increase, and that, along with a rise in inflation, will dampen bond prices.

While the threat isn’t immediate, it’s not too early to consider how you might try to protect your bond portfolio from these threats. There are a number of ways to do so. For example, you might consider moving your bond investments to mutual funds that invest in floating-rate loans or foreign bonds, both of which have become more affordable as Europe’s debt crisis has sparked a shift back to sectors viewed as so-called safe havens. Intermediate-term bond funds may also be an option for a rising-interest-rate environment because shorter-term bond prices tend to fall less sharply than longer-term bond prices when interest rates rise.

Your financial advisor can help you determine if any of these investments are appropriate for you.

Converting a traditional individual retirement account (IRA) to a Roth IRA may appeal to some investors because they have no withdrawal requirements – withdrawals from them are tax-free. But Roth IRAs aren’t for everyone.

First, the reason for converting may be flawed. Many investors want to convert to a Roth IRA because they anticipate higher U.S. tax rates, but regardless of the tax rates, most people fall into a lower tax bracket when they retire.

Second, the tax bite may hurt. Investors converting a traditional IRA to a Roth IRA have to pay income tax on any money they move.

Third, it can take 15 to 20 years for the tax-free growth of a Roth IRA to make up for the taxes paid at the time of conversion. Many investors interested in converting don’t have that much time until retirement, when they’ll start taking withdrawals.

Finally, converting can put you in a higher tax bracket right now – and the impact can be far-reaching. The money converted to a Roth IRA from a traditional IRA is considered income from a tax perspective, so if you aren’t already in the highest bracket, converting could increase your tax rate.

That, in turn, could have many implications. For example, if you’re collecting Social Security benefits, the rise in income could force you to pay taxes on those benefits.

Or if you have a child applying for college financial aid, that aid could be reduced.

Roth IRAs can be compelling investment options for many investors.

Your financial advisor can help you determine if a conversion is right for you.

The tax information in this article is merely a summary of our understanding and interpretation of some of the current laws and regulations and is not exhaustive.

Investors should consult their tax advisor for advice and information concerning their particular circumstances.

The market downturn left many investors wary of putting money into 401(k) investments. Such investments fell to $50.5 million in 2010, compared to $60.6 million in 2007.

Following are some things to consider when putting money back into a 401(k) plan:

•    Most 401(k) providers get a cut of the expense ratio on the funds in which you invest, and it is often difficult for you to know exactly what fees the 401(k) plan is charging.

•    When you leave your job, you may have to pay to keep your 401(k) plan at your old company. Some employers pay the fee to administer your plan while you work for them, but they pull the plug once you are off the payroll.

•    Your fund choices may be poorer than you think. Average 401(k) investors have 18 fund options, according to the Profit Sharing/401(k) Council of America, but they may not be the optimal fund options. Ideally, a 401(k) plan should offer a handful of  “core” funds, like a money market fund as well as bond index, domestic equity index and international equity index funds.

If you aren’t happy with your plan, you may be able to transfer your 401(k) assets to an individual retirement account (IRA). Your financial advisor can help you determine if you are eligible for such a transfer.

It’s always a good idea to keep your Individual Retirement Account (IRA) assets untouched until you can withdraw them penalty-free at age 59½, but you may need to make an exception in this economy.

How can you avoid the tax implications?

In most cases, all or part of any early withdrawal from a traditional IRA will be considered taxable income.

The taxable percentage of the withdrawal depends on whether you’ve made any nondeductible contributions over the years.

Additionally, you may get hit with a 10% penalty tax.

It’s likely impossible to avoid the income tax.

However, you might be able to avoid the 10% penalty tax by taking advantage of the following exceptions to the rule:

•    Withdrawals to cover higher education expenses for you or your spouse, child or stepchild or your or spouse’s adopted child are penalty-free.

•    Withdrawals to cover unreimbursed medical expenses that exceed 7.5% of your adjusted gross income for any tax year are penalty-free.

•    Withdrawals to cover health insurance premiums are penalty-free when they’re used to pay the premiums for you, your spouse or your dependents while you are unemployed.

Many of these techniques are complicated, however.

For example, in regard to health insurance premiums, you must receive unemployment compensation for 12 consecutive weeks under any federal or state unemployment program during the current or preceding year.

Thus, you should seek advice from a tax professional or financial advisor before using any of these strategies.

They can tell you which strategies work best, given your individual financial situation.

Choosing a financial advisor is only half the battle in ensuring that your investments are properly looked after. Finding a good one is also important.

Following are some tips to help ensure that your experience is a good one:

First, it’s a good idea to set up some ground rules. For example, you may want to ask how often you can expect to hear from your financial advisor. You’ll also want to know whether you’ll hear directly from your advisor or from a staff member. Not knowing this can lead to frustration.

Second, you’ll want to keep your financial advisor informed of your fiscal situation and goals. You likely did that when you first met with the advisor, but finances and goals can change. You may have received an inheritance, made a large purchase such as a car or a house, started caring for an elderly relative, decided to send your children to a more expensive college, or opted to retire earlier than you had originally planned. These are all situations you would want to mention to your financial advisor, as they could necessitate a change in your plan.

Third, keep in mind that your financial advisor may be available to help you with concerns other than those that were part of your original consultations. Perhaps you originally began working with a financial advisor on a single issue, such as portfolio management or retirement planning. It’s likely, however, that your financial advisor can help you with many more issues, from wealth transfer to taxation. Don’t hesitate to ask.

Many of today’s retirees are facing an unfortunate scenario. To retire on time, they’ll need to turn their depreciated savings into extra income – at a time when the bond market could start faltering.

Over the past year, bonds have been a haven for many investors seeking alternatives to the low rates available in bank deposits and money market funds.

The result was appreciation in the asset classes that have performed well since the market’s rally began. Those include corporate bonds, high-yield bonds and emerging-market debt.

But the rapid appreciation of these sectors may be behind us because they tend to underperform in rising interest rate environments. That’s because when interest rates rise, the prices of existing bonds fall as newer bonds with higher rates are issued.

Although the U.S. Federal Reserve Board may still be months away from its first interest rate increase, fixed-income investors may want to start considering their options.

One option is investing a portion of one’s portfolio in dividend-paying stocks, which can provide a dependable income stream.

When a company earns profits, it often pays a share of those profits to its shareholders. These profits – called dividends – are typically paid by large, well-established companies that generate profits regularly but are too mature to grow significantly.

Granted, the recession was hard on dividend yields because it was hard on corporate profits. Companies cut payments, driving the average yield of stocks in the S&P 500 down to 2% in March 2001. That’s far below the historical average of 3.8%. But the trend may be turning as companies see their profits improve.

Dividend-paying stocks can be found in many sectors, such as utilities and consumer staples. You can also leave the hunt for dividends to mutual fund managers who specialize in that field, by purchasing shares of a dividend-focused mutual fund.

It’s not a well-known fact, but younger retirees face a harsh penalty for working part-time. If you retire younger than normal retirement age, there’s a limit to how much you can earn and still receive full Social Security benefit payments.

The Social Security administration specifies that “normal” retirement age can vary from age 65 (if you were born in 1937 or prior) to 67 (if you were born in 1960 or later).

Whatever your normal retirement age is, after you reach it you can earn an unlimited amount of money and still qualify for full Social Security benefits.

But if you retire younger than normal retirement age, you are limited as to how much you can earn if you want to still receive full Social Security benefits. For example, before you reach normal retirement age, for every $2 you earn over $14,160, you lose $1 in Social Security benefits. It gets a little better in the actual year you reach normal retirement age, when your benefits will be reduced only when earnings exceed $37,680.

The good news is that these rules apply only apply to earned income. You can have unearned income without losing any Social Security benefits. Unearned income includes income that comes from investments such as retirement plans, pensions, annuities, interest, dividends and capital gains.

So, if you’re planning to retire early but still work, don’t worry. With some advance planning, you might be able to reduce your earned income and make up the shortfall with unearned income.