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April, 2009:

5 No-No’s for IRA Investing

Apr 30th, 2009
by jblankenship.
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prohibition-facts-by-sarahdeerIt is generally well-known that in an IRA account you have a wide range of investment choices, typically only limited by the custodian’s available investment choices.  There are, though, specific investing activities that are prohibited with IRA funds.

What’s Not Allowed for IRA Accounts?

  1. Self-Dealing.  You are not allowed to make investments in property which benefits you or another disqualified person.  A disqualified person includes your fiduciary advisor and any member of your family, whether an ancester, spouse, lineal decendant (child) or spouse of a lineal decendent.  It is important to note that this limit applies to both present and future use of a property – so if you purchased a condo and rented it out exclusively for several years and then decided to convert it to personal use, this act would disqualify the investment and potentially classify it as a distribution, to be taxed and penalized (with interest) retroactively.
  2. Borrowing.  You are not allowed to borrow funds from your IRA account.  Likewise, you are not allowed to put up your IRA account as collateral for a loan.
  3. Selling.  You are not allowed to personally sell property to your IRA account.
  4. Collectibles.  The single class of investments that you may not invest in from your IRA account is collectibles.  This includes art, antiques, gems, coins, and alcoholic beverages, among other items.  There is an exception to the coin prohibition, in that you are allowed to invest in one, one-half, one-quarter, or one-tenth ounce U.S. gold coins, or one-ounce silver coins minted by the Treasury Department with your IRA funds. You can also invest in certain platinum coins and certain gold, silver, palladium, and platinum bullion.
  5. Unreasonable Management Costs.  It is prohibited to pay an exorbitant amount to an advisor to manage your account.  This is due to the fact that it IS an allowed transaction to pay your advisor, tax-free, from your IRA specifically for managing the account.  If the amount is deemed unreasonable (e.g., obviously for services above and beyond managing the IRA account), this transaction is prohibited.
  6. (bonus!) Life Insurance. You may not purchase life insurance contracts with your IRA account funds.

Beyond these transactions, IRAs have a pretty wide scope of available investment options, as I indicated before, mostly limited by the custodian’s available investments.  In cases where the IRA funds are to be used for more complex investments, such as individual real estate transactions, a special custodian is often required, as these transactions can be very difficult to complete and manage over time and maintain the tax-qualified status.  If you’re interested in such a transaction, let me know and I’ll be happy to put you in touch with such a custodian.

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Rollover Risk

Apr 28th, 2009
by jblankenship.
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rollover-risk-by-marcin-wicharyThe idea of an IRA rollover, or a rollover IRA, isn’t necessarily a cosmic mystery – this happens all the time.  You leave your job, and you rollover your 401(k) to an IRA.  No problem, right?  Unfortunately, there often are problems with the process of moving funds from one account to another – because there are a couple of very restrictive rules regarding how this process can and cannot be done.  It’s not terribly complex, but you’d be surprised how easily these rules can trip you up.

Rollover Risk

Let’s start with a few definitions:

A Rollover is when you take a distribution from one qualified plan or IRA custodian, in the form of a check made out to you, and then you re-deposit that check into another qualified plan or IRA account (at a different custodian).  The restrictions on a true rollover (from one IRA to another IRA) are:

  1. the deposit into the new account must be made no more than 60 days after the distribution from the old custodian; and
  2. a rollover can only be done once every 365 days (and yes, 366 days if February 29th is included!).

There are several exceptions to the “once-per-year” (OPY) rule, specifically that this only applies to IRA-to-IRA rollovers.  Rollovers to or from an employer plan (either to or from an IRA or another employer plan) are not subject to the OPY rule.  Also, Roth conversion is not subject to the OPY rule as well.

The only exception that I know of with regard to the 60-day rule is if the rollover amount becomes frozen (due to bank insolvency, for example) during the 60-day period, and therefore cannot be withdrawn.  If this situation occurs, the IRA account owner must complete the rollover within 10 days after the deposit is no longer frozen.

Now, in the case of a medical issue that keeps the IRA account owner from completing the rollover, it is possible to petition the IRS for a waiver of the 60-day rule, and given appropriate circumstances these are almost automatic.

It is also important to note that the OPY rule applies separately to each IRA.

A Trustee-to-Trustee Transfer (TTT), even though it is often referred to as a “direct rollover”, is treated differently from the Rollover (described above).  These transfers, being from one custodian to another (the money never gets into the taxpayer’s hands) is an instantaneous transfer, so the 60-day rule has no bearing on it.  Also, the TTT is not restricted to the OPY rule.

Why is this so important? When would you make more than one rollover in a year?  One case might be where you were waiting for maturity of certain instruments in one IRA (like a CD, for example) and through the course of less than a year, you had two CDs come due and you took rollover distribution from each in separate checks.  The second (and any subsequent) check in the 12 month period would be disallowed and considered a taxable (and most likely penalized) distribution.

Two more rules on rollovers

In addition, the TTT helps to avoid any issues with another rule on rollovers: you are required to rollover the same property that was distributed.  This means that the IRA account owner can not receive cash as a distribution and then rollover stock shares that he’s purchased with the cash.  Likewise, you couldn’t receive shares of stock in one company, sell the shares and purchase stock in another company and rollover the new shares. One exception to this rule is that if you receive property from a company plan (like a 401(k)), you can sell the property and rollover the cash into an IRA.

If one of those transactions occurs, your rollover funds are considered excess contributions (above and beyond the annual limit) and you would be subject to 6% excess accumulation tax per year that the funds were in the account, on top of being taxed on the original distribution, and quite likely penalized as well.

The last rule I have to offer is the fact that a non-spouse beneficiary can never do a 60-day rollover; they must always do a TTT – as any check written to a non-spouse beneficiary is considered a taxable distribution, and there is no relief available if this mistake is made.

So a good rule of thumb is this: unless there is a very compelling reason, you should always go with a Trustee-to-Trustee transfer when rolling funds to an IRA – this way you’ll avoid some very unpleasant results.  If you have to do the other kind of rollover – make sure you haven’t done another within a year and you’ll be golden.

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Comprehensive Financial Planning – Explained

Apr 26th, 2009
by jblankenship.
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albert-and-the-puzzle-by-emdotFrom time to time, the question is asked of me: What exactly makes up a comprehensive financial planning engagement?  Since you know from reading about my practice that I operate in an hourly, fee-only fashion, you should know that a truly comprehensive financial planning engagement requires 10 to 15 hours of effort by the financial planner.

What exactly makes up a comprehensive financial planning engagement?

Each individual situation is going to be different, and so your mileage is likely to vary from my explanation, but what I’ll do, as a starting point, is list out the areas that are typically covered in what I’d call a comprehensive plan:

  • goal-setting – spending time understanding the wishes and desires of the client, and quantifying them in terms of time horizon and costs for use in planning; this can include retirement, college, home purchase or remodel, opening a business, parents moving in, and just about any major financial event
  • priority-setting - understanding the relative importance of each goal
  • risk analysis – explaining to the client the concepts of risk, how risk is required for return, and garnering an understanding of the tolerance level for risk given the timelines and current financial condition
  • cash flow – review of financial flows, finding those “unknown” expenditures that can be harnessed toward financial goals; understanding near-term and long-term requirements for cash flow; review of prior tax returns for any isssues there as well
  • present financial condition – review of present accounts, allocation, future inflows into those accounts; present position with regard to debt, as well as future debt planned and debt to be retired
  • projection of future cash flows – modeling the future as it pertains to the goals stated, with regard to the present financial condition and assumptions made about holdings, inflows, taxes, debt, and timelines
  • risk management – review of current insurance coverage(s), especially with regard to life, disability, and long-term care insurance needs, both now and in the future, given results from the future cash flow projections; this often also entails a review of employer-provided benefits and recommendations for participation therein
  • estate planning – review of present accounts, ensuring appropriate titling and beneficiary designation both now and in the future, given results from other components of the planning process
  • strategy development – this can entail anything from tax planning to portfolio development to insurance recommendations, debt reduction, distribution planning, and opening and funding the appropriate accounts.
  • communication of the results/recommendations – sometimes this takes a couple of hours or more on its own. The point is that the client comes away with a thorough understanding of the recommendations and the reasoning behind them.
  • implementation – not always required, but often is requested. I spend time helping the client open accounts and making allocations if required, implementing insurance coverages (reviewing policies and the like), implementing tax strategies, etc. – or sometimes the client turns the implementation completely over to me.
  • follow up – regardless of the one-time nature of your example, plans are reviewed after approximately one year to ensure that circumstances have not changed dramatically (with regard to the information that I have on hand). If the client doesn’t wish to engage in formal follow up review, then the engagement is complete.

The Reality – What Really Is Involved

Now, given the fact that a typical comprehensive financial plan entails at least three meetings with the client, each lasting on average one and a half hours, that leaves five and a half hours (on the low end) or ten and a half hours (on the high end of my estimate) to cover the remainder of the activities I’ve listed. In the case of the lower end of the spectrum, some of the components are either eliminated or reduced in scope. For example, if the client only has a 401(k), no debt other than his mortgage, is single and has no children – then obviously the planning cycle is reduced, due to the reduction in planning factors.

Now, the other thing is that many financial planners (myself included) notoriously underrecover – that is, we often spend more time on the plan than what we bill, due to additional research required, or additional time required for communication of the recommendations, or any of a myriad of activities.

Hope this gives you an idea of what is involved in a typical financial planning engagement.

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Interesting Links to Share

Apr 24th, 2009
by jblankenship.
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icy-chain-link-fence-by-existentistI wanted to take a moment to catch you up on a few things.  The first thing is that I wanted to point you to Helen Maynard’s Affine Financial Services blog, where she recently posted the very well-written article ETF’s vs. Index funds: The good, the bad, and the ugly where she makes some excellent points in comparing and contrasting these two investment vehicles.  Give it a look, you’ll learn something, I’m sure!

Secondly, I wanted to direct you to another blog, Bad Money Advice, by Mr Frank Curmudgeon.  Frank’s outspoken and cynical reviews of various “mainstays” of the financial world is priceless education.  Recently, Frank has been writing a series on Dave Ramsey’s advice, (starts here), and I have to hand it to Frank, he’s hitting the nail right on the head.  The gist is that, while Ramsey does make some valid arguments (more good than harmful), parts of what he evangelizes has a spin to it that is difficult to ignore.

And lastly, in case you happened to miss it, there was an interesting article with a quote by an interesting fellow in this month’s Money magazine.

That’s all for now…

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Reminiscing…

Apr 24th, 2009
by jblankenship.
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5th-anniversary-spoon1Earlier this week marked the five year anniversary of this blog.  Seems like an awful lot has happened during that time, from many different points of view.  I thought it would be interesting to review a couple of those early entries today, to see how they have weathered the test of time.  Keep in mind, at that time the blog entries were solely reprints of my then-quarterly newsletter…

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A Look Back At Five-Year-Old Posts

First Message:  message is as relevant today as it was then.  We know who we are, we average everyday people, and this remains the folks that I work with.

Reallocating In 5 Easy Steps:  no amazing technological advances here – the process pretty much remains the same, and continues to be important.

TIDBITS - College Savings:  Talk about the good ol’ days!  I know personally that WIU at Macomb has increased considerably from those figures.  Here’s an update with the 2009 figures (amount of increase in percentage):

Southern Illinois U Carbondale:  $18,901 (+63%)
Bradley U: $30,410 (+33%)
Illinois State U:  $19,828 (+26%)
U of Illinois:  $23,150 (+47%)
Western Illinois U:  $16,037 (+73%)

Financial Planning 101: still as relevant today as it was when originally written.

I guess that’s all a good sign, right?  That the stuff we discussed here continues to be important and relevant five years later…?  Hopefully you’ve had a chance to implement some of those recommendations over the past five years and have reaped some rewards from them.

As with just about anything, there is no magical solution to always be successful and avoid all problems in your financial life – but hopefully what you’ve seen here over the years is helpful to improve your overall success-to-problem ratio in your favor.

Thanks for five years’ worth of listening – I’ll do my best to be worthy of your attention.  Please, no spoons or wood are necessary… :-) But do let me know (leave a comment) if you like something, hate something, or if you’d like to see other topics covered.

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401(k) Fair Disclosure for Retirement Security Act of 2009

Apr 22nd, 2009
by jblankenship.
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In addition to the “tweaks” that I talked about in this post, more components of the 401(k) landscape are receiving focus.  In this particular case, we’re aiming for more disclosure and information about fees for plan participants.

401(k) Fair Disclosure for Retirement Security Act of 2009

symmetry-by-j_fiSpecifically, under this bill, 401(k) plan participants would receive information on risk, return, complete fees, and investment objectives before signing up for a plan. Plus, the fee amount for each account would be disclosed on the participant’s quarterly statement.  This may be a huge eye-opener for 401(k) plan participants, as these costs have never been disclosed to participants in the past – at least in any easily-digestible way.

In addition, the administering firm would have to provide the employer (the plan sponsor) with a complete breakdown of all expenses, including administrative fees, transaction fees, investment management fees, and any other fees charged to the overall plan.

The most controversial aspect of the legislation is the requirement that all plans provide at least one low-cost index fund, either indexed to the total stock market, the total bond market, or a combination of both.  The managed mutual funds industry has long been opposed to this component, with the argument that the plan sponsors should be free to choose any investment option they desire.  I think that the index option is a great alternative, and does nothing to negate the plan sponsor’s ability to choose a plethora of additional investment alternatives.

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Illinois’ BrightStart Plan Woes

Apr 21st, 2009
by jblankenship.
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Note: an update to this story can be found here.

If you’re an Illinois (among other states, see Note below) parent of a child heading to college or already in college, then you may already be painfully aware of the “Oppenheimer problem” that the BrightStart 529 plan has encountered.

worcester-college-by-sba73Briefly, one of the Oppenheimer mutual fund choices (formerly) available as an allocation option in the BrightStart 529 plan (Illinois’ plan, see Note below for other plans affected) was the Champion Income fund.  Last fall, during the market downturn, this particular fund experienced a 79% freefall.  Another option, the Core Bond fund, experienced a 36% drop.  These are astounding numbers, given that peer funds only experienced an 8% drop during the same period.

These two funds are part of a grouping that is typically conservative in nature, not given to wild swings in the market (up or down) – and as such, parents who chose these funds as a part of their allocation for 529 savings were expecting a conservative growth diversifier when choosing these funds.  Unfortunately, Oppenheimer funds’ management had decided to drink the kool-aid of investing in the extremely risky mortgage security derivatives that have become the poster child of the economic meltdown we’ve been experiencing.

Thus far, Oppenheimer has admitted no wrongdoing, but rather has indicated that it acted appropriately in managing the funds.

Illinois Treasurer Alexi Giannoulias is leading an effort to resolve this situation, which reportedly has cost Illinois families as much as $85 million, by negotiating with Oppenheimer.  Thus far, Oppenheimer has admitted no wrongdoing, but rather has indicated that it acted appropriately in managing the funds.  Giannoulias has indicated that he will sue the company if negotiation is fruitless.

How We Can Keep This From Happening Again

The biggest issue here is that there is very little oversight into 529 plan fund management.  There are no federally-mandated cap on fees in these funds, and precious little oversight into the management of the funds.  Since these funds are not the same mutual funds that are publicly traded, there can be some funky things going on with fee structures and investment management that isn’t as clear to the individual investor.

I believe the time has come to give these funds the same oversight and require the same disclosure as all other security investments. It’s costly enough to pay for college – families who save in these plans should deserve to know that their investments are held to the same high standard as all other investments.

Note: While the Illinois BrightStart 529 plan has been the headliner lately, several other states’ 529 plans have been hammered by the same two Oppenheimer funds: Maine (NextGen), New Mexico (Scholar’s Edge and Education Plan), Oregon (Oregon College Savings and Oppenheimer 529), and Texas (LoneStar and Texas College Savings).  Legal action is pending for each state individually.

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Education Benefits of ARRA 2009

Apr 20th, 2009
by jblankenship.
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16332570The American Recovery and Reinvestment Act of 2009 (ARRA 2009) included three provisions for higher education benefits:  changes to the HOPE education credit program, increases in the Pell Grant limits, and expansion of the types of expenses considered Qualified Higher Education Expenses for §529 college savings plans.

Changes to the HOPE Education Credit Program (renamed American Opportunity Tax Credit)

The American Opportunity Tax Credit is a re-vamp of the HOPE program, presently just for 2009 and 2010, and amounts to a credit of:

  • 100% of the first $2,000 of qualified tuition and related educational expenses, plus
  • 25% of the qualified tuition and related educational expenses over $2,000 but not more than $4,000

The maximum credit for tax years 2009 and 2010 is $2,500 (up from $1,800), and is allowed during the first four years (previously the first two years) of the student’s post-secondary education in a degree or certificate program.  For the purposes of this credit, the definition of qualified tuition and related educational expenses has been expanded to include course materials (previously excluded) in addition to tuition and fees.

Up to 40% of this credit can be refundable, unless the student is subject to kiddie-tax rules. The credit is phased out for single taxpayers with MAGI over $80,000, or married-filing-jointly filers with MAGI over $160,000.

Section 529 Plan QHEE Definition

Prior to ARRA 2009, the only way to pay for required computing equipment and services for higher education was via a Coverdell Education Savings Account.  ARRA 2009 changed the definition of Qualified Higher Education Expenses (QHEE) for §529 college savings plans to specifically include computers and computing equipment, plus internet access and related services.

This is a quite generous definition, including computing equipment and services as long as “such items are to be used by the beneficiary (of the §529 account) and the beneficiary’s family during any of the years that the beneficiary is enrolled at an eligible educational institution.”

Pell Grant

For tax year 2009, the maximum Pell Grant has been increased to $5,350, and for 2010 to $5,550, which represents an increase in the scheduled maximums of $500 for each period.

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Where To Establish Your IRA Account

Apr 18th, 2009
by jblankenship.
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Establishing and contributing to an IRA (Traditional or Roth) is pretty simple and straightforward. There is a wide variety of institutions that offer IRA accounts:  banks, savings and loans, credit unions, insurance companies, mutual fund companies, and brokerages.  There are pros and cons to each type of institution, as we’ll list below.  These alternatives represent the major options for opening your IRA, in no particular order.

federal-reserve-bank-of-new-york-by-epicharmus

Banks, Savings and Loans & Credit Unions
Pros: Banks are well-known as some of the most stable and conservative institutions in our financial industry.  For many folks, this is an assurance that there is additional safety in placing funds with these institutions, and in a way, with FDIC insurance, there is additional safety.
Cons: Since banks are conservative, until recently, their options for investment of IRAs were somewhat limited.  Traditionally, cash-oriented investments such as CDs and Money Markets were the primary means of investment within banks.  This has changed lately with some deregulation of the banks, as many offer mutual fund investments in addition to the traditional offerings.
Insurance Companies
Pros: While there are many arguments about the merits (or lack) of placing annuity investments into IRAs, this is one of the options that insurance companies bring to the table.  Annuity investments can provide a stable guaranteed income stream for retirement.
Cons: Many times the investments that insurance companies have available for IRAs are a higher cost than can be found in most other investment choices.  Annual expense ratios run in the 2% plus range.
Mutual Fund Companies
Pros: Typically the lowest-cost provider of IRAs, with a wide variety of investment offerings.  In addition, once the account is established, there are generally no transaction costs for additional contributions.  This supports the concept of dollar-cost-averaging.
Cons: many mutual funds have minimum investment levels that make investment into the funds difficult within the IRA, especially in the early years of the account.  In addition, with the exception of no-load mutual funds, typically there are sales charges associated with the funds, ranging anywhere from 2% up to 5% and more.
Brokerage
Pros: wide variety of investment choices. Depending upon the brokerage, can be a very cost effective option, in terms of transaction costs.
Cons: typically have a transaction cost with each contribution, which is in contention with the concept of dollar-cost averaging, as each individual contribution, if invested immediately, can generate a transaction fee ranging from $10 to $50, depending upon the brokerage.

As you can see, there are positives and negatives to each type of institution.  You need to be comfortable with your choice of financial institution for your IRA, as you will be dealing with the company for many years in the future.  Although you could make a change (rollover your funds) to a different institution at pretty much any time within limits, making those changes can be a hassle, so it’s best to be certain of your choice up front.

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2010 Conversions to Roth: Six Factors to Consider

Apr 16th, 2009
by jblankenship.
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If you have considered converting funds to a Roth (the IRA, not David Lee)  from a traditional IRA or a qualified (tax-deferred) plan like a 401(k), undoubtedly you have run across this tax code item: in 2010, the income limit for Roth conversions is lifted.  On top of that, the IRS will give you two years to pay the tax on your conversion, with the tax for a conversion in 2010 evenly split, coming due in 2011 and 2012.  You don’t have to split the tax, you could pay it all in 2010 if you like, which might be useful if it would be more expensive to delay the tax.

dlr-by-its_meSo – why is this a big deal?  Well, in the past, there has been an income limit of $100,000; meaning that you could not convert traditional IRA funds to a Roth IRA if your MAGI was above that level.

So, back during the bad old Bush days (Remember when?  That was before hope and change…), when the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) was passed in 2001, this particular provision was put into place.  And so, some folks have been looking forward to 2010 ever since (in spite of all of the other tax provisions that are expiring in 2010).

Six Factors to Consider Before Converting to a Roth IRA

If this provision impacts you, it makes good sense to begin planning now for the potential of converting your IRA to a Roth next year.  Here are six factors to consider:

  • If you convert funds from an IRA to a Roth IRA, it is most advantageous if you are able to pay the tax on the conversion from funds outside of your IRAs.  If you can’t do this, realize that any funds used to pay tax on the conversion will also be subject to the 10% early withdrawal penalty if no other exception applies and you’re under age 59½.
  • What is your outlook on tax rates? A Roth conversion, especially when there is a sizeable amount to convert, may be taxed at some very high rates, depending upon your situation.  For example, a couple who would normally have a MAGI of $110,000 would have a marginal 25% rate.  Add in a $200,000 Roth IRA conversion, and a portion of those funds would be taxed at as high as the 33% rate.  It only makes sense to convert if you believe the rates in the future would be higher than the rate you’d pay tax on the conversion today.
  • Does your IRA contain nondeductible contributions?  If, in years past, you have contributed nondeductible amounts to your IRA due to income limits, the Roth conversion of those amounts is a no-brainer for you.  However, you must be careful about how you do a conversion in this case, because any amount that doesn’t represent your nondeductible contributions would be considered taxable upon the conversion. (see Note below for additional explanation)
  • When do you plan to access your funds?  If it’s going to be several years (10 or more) then you will have a better chance of having recouped the tax outlay by way of the tax-free growth in the account. 
  • If you need to access the funds from this account much sooner, bear in mind that funds converted to a Roth IRA can’t be distributed for five years after the conversion.  This could throw a wrench in the entire process if you needed access sooner.
  • If you don’t plan to ever access these funds, a conversion may may sense for you, since a Roth IRA has no Required Minimum Distribution.  This way, you won’t have to deplete your IRA balance (after age 70½), and your heirs will reap the benefits of a much larger account, all tax free.

Note: A complication comes up when you have a combination non-deductible contributions and otherwise taxable growth or deductible contributions housed in the same account:  IRA rules require that distributions (including conversions) must be taken out ratably, or in the proportions of the entire account. 

For example, if you had an IRA with a $100,000 balance, of which $50,000 was non-deductible contributions, $30,000 was deductible contributions, and $20,000 was growth, then for every dollar that is distributed by conversion, fifty cents would be taxed and fifty cents would be tax-free return of your basis.

One way around this is to rollover the amounts above and beyond your nondeductible contributions into a 401(k), or other eligible plan (but not an IRA), and then convert the remaining amount (the nondeductible contributions) to your Roth IRA.  This would effectively be a tax-free maneuver.  Consult your tax advisor to make sure you’re doing this correctly.

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