The Roth 401(k)

Some employers offer 401(k) plan participants the opportunity to make Roth 401(k) contributions. If you’re lucky enough to work for an employer who offers this option, Roth contributions could play an important role in helping enhance your retirement income.

What is a Roth 401(k)?

A Roth 401(k) is simply a traditional 401(k) plan that accepts Roth 401(k) contributions. Roth 401(k) contributions are made on an after-tax basis, just like Roth IRA contributions. This means there’s no up-front tax benefit, but if certain conditions are met, your Roth 401(k) contributions and all accumulated investment earnings on those contributions are free from federal income tax when distributed from the plan. (403(b) and 457(b) plans can also allow Roth contributions.)

Who can contribute?

Unlike Roth IRAs, where individuals who earn more than a certain dollar amount aren’t allowed to contribute, you can make Roth contributions, regardless of your salary level, as soon as you’re eligible to participate in the plan. And while a 401(k) plan can require employees to wait up to one year before they become eligible to contribute, many plans allow you to contribute beginning with your first paycheck.

How much can I contribute?

There’s an overall cap on your combined pretax and Roth 401(k) contributions. You can contribute up to $18,000 of your pay ($24,000 if you’re age 50 or older) to a 401(k) plan in 2015. You can split your contribution any way you wish. For example, you can make $10,000 of Roth contributions and $8,000 of pretax 401(k) contributions. It’s up to you.

But keep in mind that if you also contribute to another employer’s 401(k), 403(b), SIMPLE, or SAR-SEP plan, your total contributions to all of these plans–both pretax and Roth–can’t exceed $18,000 ($24,000 if you’re age 50 or older). It’s up to you to make sure you don’t exceed these limits if you contribute to plans of more than one employer.

Can I also contribute to a Roth IRA?

Yes. Your participation in a Roth 401(k) plan has no impact on your ability to contribute to a Roth IRA. You can contribute to both if you wish (assuming you meet the Roth IRA income limits). You can contribute up to $5,500 to a Roth IRA in 2015, $6,500 if you’re age 50 or older (or, if less, 100% of your taxable compensation).1

Should I make pretax or Roth 401(k) contributions?

When you make pretax 401(k) contributions, you don’t pay current income taxes on those dollars but your contributions and investment earnings are fully taxable when you receive a distribution from the plan. In contrast, Roth 401(k) contributions are subject to income taxes up front, but qualified distributions of your contributions and earnings are entirely free from federal income tax.

Which is the better option depends upon your personal situation. If you think you’ll be in a similar or higher tax bracket when you retire, Roth 401(k) contributions may be more appealing, since you’ll effectively lock in today’s lower tax rates. However, if you think you’ll be in a lower tax bracket when you retire, pretax 401(k) contributions may be more appropriate. Your investment horizon and projected investment results are also important factors. Before you take any specific action be sure to consult with your own tax or legal counsel.

Are distributions really tax free?

Because your Roth 401(k) contributions are made on an after-tax basis, they’re always free from federal income tax when distributed from the plan. But the investment earnings on your Roth contributions are tax free only if you meet the requirements for a “qualified distribution,”

In general, a distribution is qualified only if it satisfies both of the following:

  • It’s made after the end of a five-year waiting period
  • The payment is made after you turn 59½, become disabled, or die

The five-year waiting period for qualified distributions starts with the year you make your first Roth contribution to your employer’s 401(k) plan. For example, if you make your first Roth contribution to the plan in December 2015, then the first year of your five-year waiting period is 2015, and your waiting period ends on December 31, 2019.

But if you change employers and roll over your Roth 401(k) account from your prior employer’s plan to your new employer’s plan (assuming the new plan accepts Roth rollovers), the five-year waiting period starts instead with the year you made your first contribution to the earlier plan.

If your distribution isn’t qualified (for example, if you receive a payout before the five-year waiting period has elapsed or because you terminate employment), the portion of your distribution that represents investment earnings on your Roth contributions will be taxable, and will be subject to a 10% early distribution penalty unless you are 59½ or another exception applies.

You can generally avoid taxation by rolling your distribution over into a Roth IRA or into another employer’s Roth 401(k), 403(b), or 457(b) plan, if that plan accepts Roth rollovers. (State income tax treatment of Roth 401(k) contributions may differ from the federal rules.)2

What about employer contributions?

While employers don’t have to contribute to 401(k) plans, many will match all or part of your contributions. Your employer can match your Roth contributions, your pretax contributions, or both. But your employer contributions are always made on a pretax basis, even if they match your Roth contributions. That is, your employer’s contributions, and investment earnings on those contributions, are not taxed until you receive a plan distribution.

What else do I need to know?

Like pretax 401(k) contributions, your Roth 401(k) contributions and investment earnings can be paid from the plan only after you terminate employment, incur a financial hardship, attain age 59½, become disabled, or die.

Also, unlike Roth IRAs, you must begin taking distributions from a Roth 401(k) plan after you reach age 70½ (or in some cases, after you retire). But this isn’t as significant as it might seem, since you can generally roll over your Roth 401(k) dollars (other than RMDs themselves) into a Roth IRA if you don’t need or want the lifetime distributions.

Employers aren’t required to make Roth contributions available in their 401(k) plans. So be sure to ask your employer if they are considering adding this exciting feature to your plan.

  Roth 401(k) Roth IRA
Maximum contribution (2015) Lesser of $18,000 or 100% of compensation Lesser of $5,500 or 100% of compensation
Age 50 catch-up (2015) $6,000 $1,000
Who can contribute? Any eligible employee Only if under income limit
Age 70 ½ required distributions? Yes No
Potential matching contributions? Yes No
Potential loans? Yes No
Tax-free qualified distributions? Yes, 5-year waiting period plus either 59 ½, disability, or death Same, plus first time homebuyer expenses (up to $10,000 lifetime)
Nonqualified distributions Pro-rata distribution of tax-free contributions and taxable earnings Tax-free contributions distributed first, then taxable earnings
Investment choices Limited to plan options Virtually unlimited
Banktruptcy protection Unlimited At least $1,245,475 (total of all IRAs)

 

Roth 401(k) Roth IRA Maximum contribution (2015) Lesser of $18,000 or 100% of compensation Lesser of $5,500 or 100% of compensation Age 50 catch-up (2015) $6,000 $1,000 Who can contribute? Any eligible employee Only if under income limit Age 70½ required distributions? Yes No Potential matching contributions? Yes No Potential loans? Yes No Tax-free qualified distributions? Yes, 5-year waiting period plus either 59½, disability, or death Same, plus first time homebuyer expenses (up to $10,000 lifetime) Nonqualified distributions Pro-rata distribution of tax-free contributions and taxable earnings Tax-free contributions distributed first, then taxable earnings Investment choices Limited to plan options Virtually unlimited Bankruptcy protection Unlimited At least $1,245,475 (total of all IRAs)

1 If you have both a traditional IRA and a Roth IRA, your combined contributions to both cannot exceed $5,500 ($6,500 if age 50 or older) in 2015

2 You can avoid tax on the non-Roth portion of your distribution (any pretax contributions, employer contributions, and investment earnings on these contributions) by rolling that portion over into a traditional IRA.

This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of Albert Aizin, and The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.

The Retirement Group is not affiliated with nor endorsed by fidelity.com, netbenefits.fidelity.com, hewitt.com, resources.hewitt.com, access.att.com, Pfizer, Verizon, ING Retirement, AT&T, Qwest, Chevron, ExxonMobil, Hughes, Northrop Grumman, Raytheon, Glaxosmithkline, Merck, Bank of America, Alcatel-Lucent or by your employer. We are an independent financial advisory group that specializes in transition planning and lump sum distribution. Please call our office at 800-900-5867 if you have additional questions or need help in the retirement planning process.

Albert Aizin is a Representative with FSC Securities and may be reached at www.theretirementgroup.com.

Organizing Your Paperwork for Tax Season

If you haven’t done it, now’s the time.

How prepared are you to prepare your 1040? The earlier you compile and organize the relevant paperwork, the easier things may be for you (or the tax preparer working for you) this winter. Here are some tips to help you get ready:

As a first step, look at your 2013 return. Unless your job, living situation or financial situation has changed notably since you last filed your taxes, chances are you will need the same set of forms, schedules and receipts this year as you did last year. So open that manila folder (or online vault) and make or print a list of the items that accompanied your 2013 return. You should receive the TY 2014 versions of everything you need by early February at the latest.

How much documentation is needed? If you don’t freelance or own a business, your list may be short: W-2(s), 1099-INT(s), perhaps 1099-DIVs or 1099-Bs, a Form 1098 if you pay a mortgage, and maybe not much more. Independent contractors need their 1099-MISCs, and the self-employed need to compile every bit of documentation related to business expenses they can find: store and restaurant receipts, mileage records, utility bills, and so on. And, of course, there’s the Affordable Care Act; if you got coverage through your state or federal marketplace, Form 1095-A is needed to fill out Form 8962.1

In totaling receipts, don’t forget charitable donations. The IRS wants all of them to be documented. A taxpayer who donates $250 or more to a qualified charity needs a written acknowledgment of such a donation. If your own documentation is sufficiently detailed, you may deduct $0.14 for each mile driven on behalf of a volunteer effort for a qualified charity.1

Or medical expenses & out-of-pocket expenses. Collect receipts for any expense for which your employer doesn’t reimburse you, and any medical bills that came your way last year.

If you’re turning to a tax preparer, stand out by being considerate. If you present clean, neat and well-organized documentation to a preparer, that diligence and orderliness will matter. You might get better and speedier service as a result: you are telegraphing that you are a step removed from the clients with missing or inadequate paperwork.

Make sure you give your preparer your federal tax I.D. number (TIN), and remember that joint filers must supply TINs for each spouse. If you claim anyone as a dependent, you will need to supply your preparer with that person’s federal tax I.D. number. Any dependent you claim has to have a TIN, and that goes for newborns, infants and children as well. So if your kids don’t have Social Security numbers yet, apply for them now using Form SS-5 (available online or at your Social Security office). If you claim the Child & Dependent Care Tax Credit, you will need to show the TIN for the person or business that takes care of your kids while you work.1,3

While we’re on the subject of taxes, some other questions are worth examining…

How long should you keep tax returns? The IRS statute of limitations for refunds is 3 years, but if you underreport taxable income, fail to file a return or file a claim for a loss from worthless securities or bad debt deduction, it wants you to keep them longer. You may have heard that keeping your returns for 7 years is wise; some tax professionals will tell you to keep them for life. If the tax records are linked to assets, you will want to retain them for when you figure out the depreciation, amortization, or depletion deduction and the gain or loss. Insurers and creditors may want you to keep federal tax returns indefinitely.4

Can you use electronic files as records in audits? Yes. In fact, early in the audit process, the IRS may request accounting software backup files via Form 4564 (the Information Document Request). Form 4564 asks the taxpayer/preparer to supply the file to the IRS on a flash drive, CD or DVD, plus the necessary administrator username and password. Nothing is emailed. The IRS has the ability to read most tax prep software files. For more, search online for “Electronic Accounting Software Records FAQs.” The IRS page should be the top result.5

How do you calculate cost basis for an investment? A whole article could be written about this, and there are many potential variables in the calculation. At the most basic level with regards to stock, the cost basis is original purchase price + any commission on the purchase.

So in simple terms, if you buy 200 shares of the Little Emerging Company @ $20 a share with a $100 commission, your cost basis = $4,100, or $20.50 per share. If you sell all 200 shares for $4,000 and incur another $100 commission linked to the sale, you lose $200 – the $3,900 you wind up with falls $200 short of your $4,100 cost basis.5

Numerous factors affect cost basis: stock splits, dividend reinvestment, how shares of a security are bought or gifted. Cost basis may also be “stepped up” when an asset is inherited. Since 2011, brokerages have been required to keep track of cost basis for stocks and mutual fund shares, and to report cost basis to investors (and the IRS) when such securities are sold.6

This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.

Citations.

1 – bankrate.com/finance/taxes/7-ways-to-get-organized-for-the-tax-year-1.aspx [2/18/15]

2 – bankrate.com/finance/taxes/premium-tax-credit.aspx [1/6/15]

3 – irs.gov/Individuals/International-Taxpayers/Taxpayer-Identification-Numbers-%28TIN%29 [2/2/15]

4 – irs.gov/Businesses/Small-Businesses-&-Self-Employed/How-long-should-I-keep-records [1/27/15]

5 – irs.gov/Businesses/Small-Businesses-&-Self-Employed/Use-of-Electronic-Accounting-Software-Records;-Frequently-Asked-Questions-and-Answers [2/9/15]

6 – turbotax.intuit.com/tax-tools/tax-tips/Rental-Property/Cost-Basis–Tracking-Your-Tax-Basis/INF12037.html [2014]

This material was prepared by Peter Montoya Inc, and does not necessarily represent the views of Albert Aizin, and The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.

The Retirement Group is not affiliated with nor endorsed by fidelity.com, netbenefits.fidelity.com, Chevron, Hughes, hewitt.com, resources.hewitt.com, access.att.com, ING Retirement, AT&T, Qwest, Verizon, Bank of America, Northrop Grumman, Raytheon, ExxonMobil, Glaxosmithkline, Merck, Pfizer, Alcatel-Lucent or by your employer. We are an independent financial advisory group that specializes in transition planning and lump sum distribution. Please call our office at 800-900-5867 if you have additional questions or need help in the retirement planning process.

Albert Aizin is a Representative with FSC Securities and may be reached at http://www.theretirementgroup.com.

Comparing Bond Yields

Coupon Rates and Current Yield

If you’re considering investing in a bond, one of the factors you need to understand is its yield. But it’s important to know exactly what type of yield you’re looking at.

What exactly is “yield?” The answer depends on how the term is used. In the broadest sense, an investment’s yield is the return you get on the money you’ve invested. However, there are many different ways to calculate yield, particularly with bonds. Considering yield can be a good way to compare investments, as long as you know what yields you’re comparing and why.

Coupon rate

People sometimes confuse a bond’s yield with its coupon rate (the interest rate that’s specified in the bond agreement). A bond’s coupon rate represents the amount of interest you earn annually, expressed as a percentage of its face (par) value. If a $1,000 bond’s coupon rate pays $50 a year in interest, its coupon rate would be 5%.

The coupon rate is typically fixed. Though it does represent what a bond pays, it’s not the best measure of the return you’re getting on that investment.

Current yield

A bond’s current yield represents its annual interest payments as a percentage of the bond’s market value, which may be higher or lower than par. As a bond’s price goes up and down in response to what’s happening in the marketplace, its current yield will vary also. For example, if you bought a $1,000 bond with a 5% coupon rate for $900 on the open market, its current yield would be 5.55% (the $50 annual interest divided by the $900 purchase price). If you bought the same $1,000 bond for $1,200, the current yield would be 4.16% ($50 divided by $1,200).

If you buy a bond at par and hold it to maturity, the current yield and the coupon rate would be the same. However, for a bond sold at a premium or a discount to its face value, the yield and the coupon rate are different.

If you are concerned only with the amount of current income a bond can provide each year, then calculating the current yield may give you enough information to decide whether you should purchase that bond. However, if you are interested in a bond’s performance as an investment over a period of years, or you want to compare it to another bond or other income-producing investment, the current yield will not give you enough information. In that case, yield to maturity will be more useful.

Watching the Yield Curve

Bond maturities and their yields are related. Typically, bonds with longer maturities pay higher yields. Why? Because the longer a bondholder must wait for the bond’s principal to be repaid, the greater the risk compared to an identical bond with a shorter maturity, and the more return investors demand.

If you were to draw a line on a chart that compares the yields of, for example, Treasury securities with various maturities, you would typically see a line that slopes upward as maturities lengthen and yields increase. The greater the difference between the yields on T-bills and 30-year bonds, the steeper that slope. A steep yield curve often occurs because investors want greater compensation for tying up their money for longer periods and running the risk that inflation will cut net returns over time. A flat yield curve means that there is little difference between short and long maturities.

However, sometimes the yield curve can actually become inverted; in this case, short-term interest rates are higher than long-term rates. For example, in 2004 the Federal Reserve Board began increasing short-term rates, but long-term rates didn’t rise as quickly. A yield curve that stays inverted for a period of time is believed to indicate a recession may be about to occur.

Yield to Maturity, Yield to Call

Yield to maturity

Yield to maturity (YTM) reflects the rate of return on a bond at any given time (assuming it is held until its maturity date). It takes into account not only the bond’s interest rate, principal, time to maturity, and purchase price, but also the value of its interest payments as you receive them over the life of the bond. Yield to maturity includes the additional interest you could earn by reinvesting all of the bond’s interest payments at the yield it was earning when you bought it.

If you buy a bond at a discount to its face value, its yield to maturity will be higher than its current yield. Why? Because in addition to receiving interest, you would be able to redeem the bond for more than you paid for it. The reverse is true if you buy a bond at a premium (more than its face value). Its value at maturity would be less than you paid for it, which would affect your yield.

Example: If you paid $960 for a $1,000 bond and held it to maturity, you would receive the full $1,000 principal. The $40 difference between the purchase price and the face value is profit, and is included in the calculation of the bond’s yield to maturity. Conversely, if you bought the bond at a $40 premium, meaning you paid $1,040 for it, that premium would reduce the bond’s yield because the bond would be redeemed for $40 less than the purchase price.

Why is yield to maturity important?

Yield to maturity lets you accurately compare bonds with different maturities and coupon rates. It’s particularly helpful when you are comparing older bonds being sold in the secondary market that are priced at a discount or at a premium rather than face value. It’s also especially important when looking at a zero-coupon bond, which typically sells at a deep discount to its face value but makes no periodic interest payments. Because you receive all of a zero’s return at maturity, when its principal is repaid, any yield quoted for a zero-coupon bond is always a yield to maturity.

Yield to call

When it comes to helping you estimate your return on a callable bond (one whose issuer can choose to repay the principal before maturity), yield to maturity has a flaw. If the bond is called, the interest payments will come to an end. That reduces its overall yield to the investor. Therefore, for a callable bond, you also need to know what the yield would be if the bond were called at the earliest date allowed by the bond agreement. That figure is known as its yield to call; the calculation is the same as with yield to maturity, except that the first call date is substituted for the maturity date.

A bond issuer will generally call a bond only if it’s profitable for the issuer to do so. For example, if interest rates fall below a bond’s coupon rate, the issuer is likely to recall the bond and borrow money at the newer, lower rate, much as you might refinance your mortgage if interest rates drop. The less time until the first date the bond can be called, and the lower that current interest rates are when compared to the coupon rate, the more important the yield-to-call figure becomes.

Why is yield to call important?

If you rely on the income from a callable bond–for example, if it helps pay living expenses–yield to call is especially significant. If the bond is called at a time when interest rates are lower than when you purchased it, that reinvested principal might not provide the same amount of ongoing income. Why? Because you would likely have difficulty getting the same return when you reinvest unless you took on more risk.

Comparing Taxable and Tax-Free Yields

$5,000 taxable bond paying 5% interest $5,000 municipal paying 3.5% Federal tax bracket 28% 33% 35% 39.6% Annual interest $250 $250 $250 $250 $175 Paid in taxes $70 $82.50 $87.50 $99 $0 Net income $180 $167.50 $162.50 $151 $175

 

  $5,000 taxable bond paying 5% interest $5,000 municipal paying 3.5%
  Federal tax bracket  
28% 33% 35% 39%
Annual interest $250 $250 $250 $250 $175
Paid in taxes $70 $82.50 $87.50 $99 $0
Net income $180 $167.50 $162.50 $151 $175

 

Note: This hypothetical example is intended only as an illustration and does not reflect the return of any specific portfolio.

It’s important to consider a bond’s after-tax yield–the rate of return earned after taking into account taxes (if any) on income received from the bond. Some bonds–for example, municipal bonds (“munis”) and U.S. Treasury bonds–may be tax exempt at the federal and/or the state level. However, most bonds are taxable.

Consider what you keep

A tax-exempt bond often pays a lower interest rate than an equivalent taxable bond, but may actually have a higher yield once the impact of taxes has been factored in. Whether this is true in your case depends on your tax bracket. It also can be affected by whether you must pay not only federal but state and local taxes as well.

For example, let’s say you consider investing in either Bond A, a tax-exempt bond paying 4% interest, or Bond B, a taxable bond paying 6% interest. You want to find out whether Bond A or Bond B would be a better investment in terms of after-tax yield. For purposes of this illustration, let’s also say you are in the 35% federal tax bracket and do not have to pay state taxes.

You determine that Bond A’s after-tax yield is 4% (the same as its pretax yield, of course). However, Bond B’s yield is only 3.8% once taxes have been deducted. You’d probably decide that tax-exempt Bond A would be better because of its higher after-tax yield.

The impact of being tax-free

In order to attract investors, taxable bonds typically pay a higher interest rate than tax-exempt bonds. Why? The associated tax exemption effectively increases the after-tax value of a tax-free bond’s yield. That tax advantage can mean a difference of several percentage points between a corporate bond’s coupon rate–the annual percentage rate it pays bondholders–and that of a muni with an identical maturity period.

Still, as the earlier example demonstrates, a tax-free bond could actually provide a better after-tax return. Generally, the higher your tax bracket, the higher the tax-equivalent yield of a muni bond will be for you.

Comparing apples to oranges

To make sure you’re not comparing apples to oranges, you can apply a simple formula that involves your federal marginal tax rate (the income tax rate you pay on the last dollar of your yearly income). The formula depends on whether you want to know the taxable equivalent of a tax-free bond, or the tax-free equivalent of a taxable bond. Calculating the taxable equivalent of a tax-free bond requires subtracting your marginal tax rate from 1, then dividing the tax-free bond’s annual yield by the result. To calculate the tax-free equivalent of a taxable bond, you subtract your tax rate from 1, then multiply it by the taxable bond’s yield.

If a taxable bond also is subject to state and local taxes and the tax-exempt isn’t, the tax-equivalent yield on the tax-free bond could be even lower and still come out ahead.

A financial professional can help you compare taxable and tax-free bonds, and evaluate how to maximize the benefits of both.

What’s Taxable, What’s Not

Comparing taxable and tax-free yields involves making sure you understand a bond’s tax status. The interest on corporate bonds is taxable by local, state, and federal governments. However, interest on bonds issued by state and local governments–generically called municipal bonds, or munis–generally is exempt from federal income tax. If you live in the state in which a specific muni is issued, it may also be tax free at the state or local level.

Unlike munis, the income from Treasury securities, which are issued by the U.S. government, is exempt from state and local taxes but not from federal taxes. The general principle is that federal and state/local governments can impose taxes on their own level, but not at the other level; for example, states can tax securities of other states but not those of the federal government, and vice versa.

As is true of almost anything that’s tax-related, munis can get complicated. A bond’s tax-exempt status applies only to the interest paid on the bond; capital gains realized from any increases in the bond’s value are taxable when the bond is sold.

When are munis taxable?

Specific muni issues may be subject to federal income tax, depending on how the bond issuer will use the proceeds. If a bond finances a project that offers a substantial benefit to private interests, it is taxable at the federal level unless specifically exempted. For example, even though a new football stadium may serve a public purpose locally, it will provide little benefit to federal taxpayers. As a result, a muni bond that finances it is considered a so-called private-purpose bond.

Also known as private activity bonds, taxable munis are those in which 10% or more of the bond’s benefit goes to private activities, or 5% of the proceeds (or $5 million if less) are used for loans to parties other than government units. Other public projects whose bonds may be federally taxable include housing, student loans, industrial development, and airports

Even though such bonds are subject to federal tax, they still can have some advantages. For example, they may be exempt from state or local taxes. And you may find that yields on such taxable municipal bonds are closer to those of corporate bonds than they are to tax-free bonds.

Agencies and GSEs (government-sponsored enterprises) vary in their tax status. Interest paid by Ginnie Mae, Fannie Mae, and Freddie Mac bonds is fully taxable at federal, state, and local levels. The bonds of other GSEs, such as the Federal Farm Credit Banks, Federal Home Loan Banks and the Resolution Funding Corp. (REFCO), are subject to federal tax but exempt from state and local taxes. Before buying an agency bond, verify its tax status.

Don’t forget the AMT

To further complicate matters, interest from private-purpose bonds may be specifically exempted from regular federal income tax, but still may be a factor in determining whether the alternative minimum tax (AMT) applies to you. Even if you are not subject to the AMT when you purchase a bond, more people are feeling its impact each year, and the interest from a private-purpose bond could change your status. A tax professional can evaluate a bond’s potential impact on your AMT liability.

Pay attention to muni bond funds

Just because you’ve invested in a municipal bond fund doesn’t mean the income you receive is automatically tax free. Some funds invest in both public-purpose and private-purpose munis and must disclose on their yearly 1099 forms how much of the tax-free interest they pay is subject to AMT. If you own a muni bond fund, review this information periodically, especially if you think you might be subject to the AMT. Note: Before investing in a mutual fund, carefully compare its investment objectives, risks, fees, and expenses, which can be found in the prospectus available from the fund. Read the prospectus carefully before investing. A bond fund is subject to the same inflation, interest-rate, and credit risks association with its underlying bonds. As interest rates rise, bond prices typically fall, which can adversely affect a bond fund’s performance.

Use a tax advantage where it counts

Be careful not to make a mistake that is common among people who invest through a tax-deferred account, such as an IRA. Because those accounts automatically provide a tax advantage, you receive no additional benefit by investing in tax-free bonds within them. By doing so, you may be needlessly forgoing a higher yield from a taxable bond. Tax-free bonds are best held in taxable accounts.

This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of Albert Aizin, and The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.

The Retirement Group is not affiliated with nor endorsed by fidelity.com, netbenefits.fidelity.com, hewitt.com, resources.hewitt.com, access.att.com, ING Retirement, AT&T, Qwest, Chevron, Hughes, Northrop Grumman, Merck, Raytheon, Pfizer, ExxonMobil, Glaxosmithkline,  Verizon, Bank of America, Alcatel-Lucent or by your employer. We are an independent financial advisory group that specializes in transition planning and lump sum distribution. Please call our office at 800-900-5867 if you have additional questions or need help in the retirement planning process.

Albert Aizin is a Representative with FSC Securities and may be reached at www.theretirementgroup.com.

 

Separately Managed Accounts: Tailored to Suit You

Mutual funds have been one alternative for many investors seeking professional money management. But when you buy shares of a mutual fund, your assets are pooled with those of other fund shareholders. You gain professional money management, but the fund’s manager certainly can’t tailor its portfolio to meet your individual requirements.

For investors who want or need a more customized approach–for example, in order to better manage their tax liability or control individual stock holdings–separately managed accounts (SMAs) have become popular. Historically used by institutional investors and high-net-worth individuals, SMAs are now available to a wider group of investors as an alternative to mutual funds, though SMAs typically still require a higher minimum investment than a mutual fund might.

What is an SMA?

An SMA is a personal investment account that is customized and managed for you by one or more professional money managers. In an SMA, your assets are not commingled with those of other investors. With a mutual fund, you buy and sell shares of the fund. Even though each fund share represents a proportionate ownership of individual securities within the fund, your share of each of those securities is tiny. By contrast, you are the sole owner of each security within your separately managed account. You also may be able to place securities you already own in an SMA; with mutual funds, you can’t. Typically, the account owner has the ability to customize the account by excluding certain securities or industries, or employing tax-advantages vehicles.

Why is that control important? It increases your ability to coordinate the sale of specific securities with the rest of your overall financial plan.

It was once common for SMA programs to require a minimum of $1 million in investable assets, but today you can find separately managed accounts with minimums as low as $50,000. SMAs’ lower minimums, along with a growing appreciation of their unique features, may be reasons for their increasing popularity.

Is an SMA the same thing as a wrap account?

Both wrap accounts and SMAs charge fees based on the size of assets in the account, and the terms sometimes are used interchangeably. However, with a wrap account, your financial professional may serve as the account’s money manager, selecting individual securities or mutual funds for your portfolio. With an SMA, your financial professional may rely on a separate money manager (or multiple managers) to handle the day-to-day management of the portfolio or specific components of it. For example, with an SMA, you may be able to have a money manager who specializes in bonds manage that portion of the portfolio, while another manager who specializes in stock handles the equity portion. An SMA must be managed by a registered investment advisor, who may be independent or part of the same firm as your financial professional.

How SMAs trump mutual funds on taxes

Mutual funds have an inherent lack of tax efficiency. When you buy shares of a mutual fund, you automatically get a share of its embedded tax liabilities. By law, mutual funds are required to pay out realized capital gains to all fund holders, regardless of how long you have held its shares.

For example, if you buy shares in a mutual fund right before a distribution date, you may receive a distribution and have to pay capital gains taxes even though you may have held the fund for only a short amount of time. The lack of tax efficiency can be a greater problem for actively managed mutual funds that buy and sell securities frequently than it is for indexed mutual funds.

Also, some fund investors can find themselves owing income tax on their fund investment, even though the fund may have declined in value during the year. If a fund manager sells some of a fund’s holdings at a profit but other holdings drop in value, the fund can have a capital gains distribution even though its overall net asset value is lower.

By contrast, each security held in an SMA has an individual cost basis. That allows you to make specific tax-motivated moves. For example, you can generally request that your manager sell a position with an unrealized loss in order to offset capital gains, thus reducing your income tax liability.

Example: You sold a vacation home at a profit, but do not qualify for any exclusion. As a result, you owe capital gains taxes on that gain. To reduce your tax liability, you instruct your SMA manager to sell part of your position in a stock that has dropped in value. The manager sells enough stock to ensure that the losses on it offset any capital gains taxes you would owe as a result of the real estate sale.

How SMAs compare with mutual funds on trading costs, fees, and performance

Unlike traditional brokerage accounts, which are commission-based, SMA fee structures are asset-based. They typically cover the investment management fee, trading costs, custody, reporting, and financial planning services. One thing to consider when comparing mutual fund expenses against SMA fees is the “invisible” trading costs incurred by mutual funds. Mutual fund expense ratios cover fund management fees, administrative costs, and other operating expenses. However, they don’t cover trading costs, which include brokerage commissions whenever the fund buys or sells securities. Although these trading costs can vary significantly by mutual fund (depending in large part on their annual turnover rates), estimates of these costs range on average from 0.5% to 1.5% but can be higher. Also, mutual funds often carry a certain amount of cash as a cushion in case they experience a wave of redemptions from investors. That cash can act as a drag on performance. If a fund has to sell securities to meet redemption demands, that also can affect its results. Though an SMA involves its own risks and doesn’t automatically guarantee you’ll have better returns, you don’t have to worry about the impact of other investors’ actions, because an SMA has no other investors. Because of the different ways in which fees for mutual funds and separately managed accounts are calculated, it can be challenging to compare those fees. Generally speaking, the larger your account, the more likely you are to benefit from an SMA. Before investing, ask your financial professional to do an “apples to apples” comparison between SMAs and mutual funds, including total fees and trading costs, to determine which is the better deal in terms of overall costs.

How SMAs can be customized for your specific situation

Another important feature of SMAs is their ability to allow you to exclude certain securities. You also can set sector guidelines to avoid investing in a sector you might disapprove of (for example, tobacco or casino stocks). This flexibility allows you to better tailor your asset allocation for your own unique circumstances and desires–key considerations for many investors with concentrated stock positions.

Example: You work for a large company that is a mainstay of most large-cap stock indexes, and you also hold shares in the company as a result of having exercised stock options. You instruct your SMA’s manager not to buy your company’s stock, to prevent your net worth being too dependent on one company.

However, don’t expect to micromanage every single trade, as you might with a traditional brokerage account. Within the guidelines you set, the money manager typically will have discretion to implement strategies that he or she feels will provide the best returns for you. (After all, if you want to make all the decisions yourself, it probably doesn’t make sense to hire a professional money manager.) However, you still have flexibility to integrate those decisions with the rest of your financial concerns. And you’ll always be able to track what has been bought and sold on your behalf.

The bottom line

For investors who place a priority on control and tax efficiency, and have the necessary capital, an SMA program may make a lot of sense.

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This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of Albert Aizin, and The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.

Albert Aizin is a Representative with FSC Securities and may be reached at www.theretirementgroup.com.