Personal Finance Articles

“In this world nothing can be said to be certain, except death and taxes.”

This truism, attributed to Ben Franklin, raises the unthinkable: What will happen to your spouse if you die first? Or, more specifically, how can you plan for the best disposition of your Individual Retirement Account (IRA) to make the changeover relatively painless?

An IRA allows you to save money for retirement, tax deferred. Only amounts actually withdrawn from an IRA in retirement are taxable; all remaining amounts continue to grow, tax deferred, until withdrawn.

If you have an IRA, are withdrawing income from it, and have listed your partner as your beneficiary, there are choices he or she will have: Your spouse won’t have to take a lump-sum withdrawal and pay all of the income tax on it at once.

Of course, he or she can take a lump-sum withdrawal and report that entire amount as taxable income in the year the account was liquidated. But another option is treating the IRA as an “inherited” IRA and taking required minimum distributions (RMDs.) Alternatively, he or she can create a “spousal rollover” IRA.

Under the spousal rollover option, your spouse can use his or her age to determine when RMDs must begin and the correct life expectancy factor to use when calculating the RMDs.

This may be the most appealing option, but the takeaway is that you and your spouse should plan ahead. As individual circumstances differ, also consult with your advisor before making a final decision.

Your will is one way to plan for the distribution of your assets on your death. But it’s only one tool in your estate-planning kit, and many people establish a revocable living trust as well as a will.

A revocable living trust establishes a legal entity with the power to hold title to assets. The trust agreement lists the assets held in the trust, the individual with the power to manage and distribute those assets (the trustee), and the individuals entitled to benefit from those assets (the beneficiaries).

It allows you the flexibility of making changes during your life as circumstances change. And, depending on state law, you may be able to act as trustee and receive income from the trust as a beneficiary during your life.

The advantage of a revocable living trust is that whereas a will must go through the probate process, a revocable living trust typically avoids this and the pitfalls usually associated with it.

Because the trust is unlikely to be subject to the probate process, distributions in accordance with the terms of the trust will not be delayed and can occur as soon as practicable after your death.

As well, relatives unhappy with the situation will find it difficult to challenge the provisions of the trust and will be forced to bring litigation against the trustee.

And, since it will pass outside the probate process, the trust agreement is more likely to remain confidential and will not be subject to public scrutiny.

A revocable living trust is not for everyone, however. Establishing one requires the services of an estate planning professional. There can be federal and state tax implications, depending on how the trust is structured.

As a result, individuals considering using a revocable living trust as part of their estate plan should consult their advisor and an attorney specializing in estate planning for advice and assistance.

Today, anyone with an Internet connection can obtain real-time information about stock prices that makes trading look easy. And many day traders are buying into this, making rapid, large-volume trades themselves.

You may think these investors are only hurting themselves when things go wrong, but your investments can be affected, too. In fact, day trading can increase stock-market volatility, driving prices to astronomical heights one day and sending them freefalling the next.

Managing purchases and sales can be difficult when the market is moving quickly, and these dramatic shifts can be seriously disruptive for mutual-fund portfolio managers, who typically establish positions for longer terms.

To try to manage volatility, portfolio managers may need to keep more cash on hand for emergency purchases, and may need to sell a security before its ideal time.

Regardless of how talented or seasoned a portfolio manager is, it’s difficult to protect a mutual fund completely from market turbulence caused by day traders. But mutual funds are still great additions to your portfolio: Over the long term, investing in a mutual fund may actually minimize swings in the market.

How? Mutual funds offer diversification that may help lessen the impact of market highs and lows. Additionally, because mutual funds tend to hold securities for long periods of time, they may be better equipped to ride out violent intra-day market swings.

If you – unlike the day traders – are in it for the long term, your mutual funds can be a calming influence in a turbulent market.

Did the taxman come for you in 2013? If so, you may want to consider how to minimize your tax burden in 2014 – and that means understanding that a losing year could still result in capital gains (and capitals-gains taxes).

Capital Gains Aren’t Realized until Assets Are Sold

A capital gain is an increase in the value of an asset (which includes everything from real estate to stocks and mutual funds). The gain is not realized until the asset is sold. So if your investments have appreciated and you haven’t sold them, you won’t have any capital gains, correct?

Not if you own mutual funds, which are pools of investor funds that are managed by a professional. By law, mutual-fund managers must pass through to shareholders the capital gains (and losses) realized from the sale of securities in their portfolios; so you could end up paying capital-gain taxes on your mutual funds even though the fund overall was down for the year.

One Profitable Stock Can Impact Your Taxes

This happens because one security in a mutual-fund portfolio may be sold at a profit, while the majority of securities in the same portfolio are down. As a result, it would be a losing year for the fund, but the capital gain from the one profitable security would be passed on to all the fund’s shareholders.

For example: Your mutual fund bought a security in 2007 for $15 a share. At the start of 2013, the fund sold the security for $30 a share, an overall profit of $15 a share.

However, during 2013, the rest of the fund’s holdings depreciated. So, you’d end up with a down year for the fund, but would still have to pay capital-gains tax for the security that appreciated.

The lesson: Don’t assume that a losing year won’t result in capital-gains taxes – and plan accordingly for 2014.

For many investors, a solid mutual fund performs in line with its benchmark; for others, it’s a fund that zooms ahead of the market. But these aren’t necessarily the best ways to judge a fund.

Mutual funds, like the stocks and bonds they hold, are subject to market cycles. Sometimes they perform well and other times they perform poorly. Some investors try to “time the market,” by moving in and out of a fund, but this can be costly. The market moves quickly; you could easily end up selling low and buying high, triggering a higher tax bill.

Portfolio managers also haven’t the flexibility to adjust their portfolios to meet changing market cycles; a bond-fund portfolio manager is usually required by the fund’s prospectus to invest in bonds – even when the bond market is down.

A diversified portfolio based on your goals, risk tolerance, and time horizon can minimize market concerns. It won’t eliminate risk, but a diversified portfolio can help provide you a cushion in a downturn. When some funds perform poorly, others may be performing well. This balances your overall return.

Just as goals, risk tolerance, and time horizon help you create your portfolio, these factors should also guide you in deciding when to change it.

In creating your portfolio, you were required to consider how much volatility you can tolerate. If your portfolio begins to exceed your volatility tolerance, re-examine it. You may want to consider dropping losers.

However, this can be a difficult decision; ask your advisor for help.

Investors own mutual funds, in part, to create a diversified portfolio that includes a number of asset classes and securities. But in their effort to diversify, some may inadvertently have invested in many of the same asset classes and securities. This overlap could result in a portfolio that is inconsistent with their financial goals and risk tolerance.

How does overlap occur? Your funds could hold some securities in the same asset class, such as large-cap stocks. And they could even hold some of the same securities.

To detect overlap, you could look at the top 10 holdings for each fund you own (generally available in shareholder reports and fact sheets), determine the asset class for each holding, then see if there is any repetition among asset classes and securities. Or you could ask your advisor.

Your advisor may not be aware of all your holdings, and therefore would be unable to spot duplications. You can save your own time and energy, by asking him or her to help you sort through your portfolio to find any potential overlaps.

Ideally, you will already have a target asset allocation, or target mix of asset classes and sectors. If you or your advisor uncover any asset class overlap in your portfolio, you may want to take steps to correct it. He or she likely will recommend you gradual shift investments into asset categories and industries where you need to increase your exposure.

To prevent future overlap, you should be careful not to purchase a mutual fund or stock without considering its effect on your overall investment strategy. Even if you don’t make changes, you and your advisor should probably check your portfolio regularly for overlap resulting from market changes.

Your focus should be on your long-term financial goals. Build an annual portfolio checkup into your plans to ensure against overlap.

Roth IRAs may soon assume a greater role in many people’s retirement planning, as distributions from these accounts are not subject to the same taxes as other income.

Roth IRAs are individual retirement accounts that allow you to set aside after-tax income up to a specified amount each year. Because you pay taxes on the money now, earnings on the account are tax free, as are withdrawals (if taken after age 59½.)

They have long appealed to investors with lower incomes now than they expect to have in the future, as well as investors who think taxes will rise, not fall. However, now there’s a new reason to consider a Roth IRA: the Affordable Care Act (ACA).

Under the ACA, a new 3.8 percent tax is imposed on unearned net investment income of taxpayers with modified adjustable gross income (MAGI) greater than $200,000 for individuals, or $250,000 for married couples filing jointly.

If you meet those income thresholds, you’ll pay 3.8 percent more in federal income tax on whichever is less: your investment income or the amount of your MAGI that exceeds $200,000 or $250,000.

Although income received from a traditional IRA, 401(k) or pension isn’t subject to the additional tax, it can push your other income above the threshold. Withdrawals from Roth IRAs don’t count as income, so they won’t help push you over the $200,000 or $250,000 threshold.

Your advisor will explain the tax implications of investing in a Roth IRA and help you choose what is right for you.

Inflation has not been an issue for the past several years, but eventually it’s bound to return. And, by the time it arrives, it may be too late to protect your purchasing power. Now is the time to consider your options before inflation is on your doorstep. Here are some ways to protect yourself now from inflation later:

Treasury Inflation Protected Securities (TIPS)

Most bonds pay a fixed amount of interest each year until maturity. As a result, when you invest in bonds, your income is eroded by inflation; for example, if your bond portfolio returns 5 percent per year, and inflation is 3 percent, your actual return is only 2 percent.

TIPS are different. These bonds, issued by the federal government, are directly linked to the Consumer Price Index (CPI) – a common measure of inflation. So, when inflation rises, the income you receive from TIPS rises as well.

Stocks

As you know, stock prices fluctuate. In times of economic uncertainty – such as rising inflation – those fluctuations can be more pronounced. Even so, stocks can help protect a portfolio from inflation. That’s because when inflation rises, many companies can raise their product prices to keep their profit margins high. And high profit margins often lead to high equity prices.

Real estate or REITS

Real-estate prices tend to rise along with CPI. For many investors, however, investing directly in property is too expensive. Real estate investment trusts (REITs) are another option. These are pools of properties with shares that can be bought and sold much like stocks. Just like stocks, however, they may be volatile.

While there are many options for protecting yourself against inflation, there’s one option you shouldn’t choose, and that’s not investing at all. Investors who decide to invest solely in Treasury bills, certificates of deposit, and savings accounts must accept the fact that inflation may eat away at their investment return.

Some 10,000 Americans will retire each day, some more successfully than others. Here are three mistakes you should avoid to ensure you’re one of the successes:

Mismanaging Social Security benefits

Many retirees collect Social Security benefits as soon as they are eligible at age 62, but doing so comes at a cost: You’ll collect less each month than you would have if you had waited until age 65. Many believe that if you live a long time, it evens out, but you may not want to bet on that, especially if you don’t need the benefits to cover living expenses. Delaying benefits until age 70 can boost your payout by as much as 70 percent. So think twice before you take benefits at age 62.

Failing to create a budget

Some new retirees feel flush with cash…and spend. Remodeling projects are common splurges, as are one-time big-ticket purchases, such as boats and cars. These large purchases, however wonderful, can make a big dent in the money you’re going to need to live on.

Even daily expenses can add up without a budget. Research indicates that when people suddenly have free time, they tend to increase spending. These problems can be avoided by creating and maintaining a budget that’s realistic for today’s market environment and your lifestyle.

Not having a life plan

If you’re a typical new retiree, you’ve probably spent a lot of time thinking about the financial side of retirement, but there’s more to your golden years than living within your means. What are you going to do with all your free time?

Not knowing that can lead to a whole range of emotional difficulties. Smart retirees “test drive” their new lifestyle by taking more leisure time as retirement approaches. They realize they’ll need to develop new routines, hobbies and networks. Test driving helps them envision a successful future.

Many people have taken advantage of reverse mortgages as a means of converting home equity into cash. However, the rules are changing, and homeowners may not be able to borrow as much.

When you get a reverse mortgage, the bank will give you the option of receiving a lump sum, a line of credit or monthly payments. It is paid off (including interest) when you die, move or sell your house.

Currently, there are two types of reverse mortgages: “standard”, which allow borrowers to receive 56-75 percent of a home’s appraised value; and “saver”, where they receive less.

These will be merged as part of the rule changes. As a result, borrowers may find that they can’t access as much of their home’s value as they could with a standard reverse mortgage, but may receive more than with a “saver.”

Also likely is a cap on the amount borrowed in the first year of a loan, although the percentage is currently undetermined. If your home is worth $200,000, and you are eligible to borrow 75 percent ($150,000), the imposition of, for example, a 60 percent cap would mean you could only borrow up to $90,000 (60% of $150,000) in the first year.

As well, homeowners who need more than 60 percent of the loan to pay off their regular mortgage can take up to the entire amount they’re eligible to borrow immediately. However, a fee will be charged.

(Editor’s note: Changes were expected this fall; others will come later. This represents the situation at press time.)