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Book Review: A Random Walk Down Wall Street

A Random Walk Down Wall Street

A Random Walk Down Wall Street (Photo credit: Wikipedia)

Right from the start this book will be an excellent read for both financial advisors as well as their clients. Dr. Malkiel provides academic insight on the reasons why passive management works and some great commentary on the use of index funds as part of someone’s overall portfolio.

This was the second time I read this book and certainly not the last. It’s great reinforcement on why we invest our clients’ money the way we do and provides solid academic evidence that doing anything to the contrary is counterproductive, more expensive and simply playing a loser’s game.

Some of the bigger takeaways from the book are Dr. Malkiel’s thoughts and research on the different part of the Efficient Market Hypothesis or EMH. The EMH consists of three parts – the strong form, the semi-strong form and the weak form. The EMH essential admits that markets are efficient – meaning that current prices of stocks reflect all available information and prices adjust instantly to any changes in that information.

The weak form of the EMH rejects technical analysis as a way for beating the market and getting superior returns. Technical analysis can best be described as using past information to exploit future stock picks. Examples of exploiting such information are through charting, which is analyzing a stock based on its pattern of movement on a chart. Other examples given are those of anomalies that investors try to exploit such as the January Effect and the Dogs of the Dow.

The semi-strong form of the EMH says that analyzing a company’s financials, managers, and quarterly and annual reports will not help an investor or manager find stocks that will beat the market overall, thus bot technical and fundamental analysis of companies is futile.

The strong form of the EMH goes even further by stating that even inside information (think Martha Stewart and ImClone) won’t lead investors to superior returns over the market. So technical and fundamental analysis along with insider information are useless.

Admittedly, we know that anomalies exist and there are going to be differences here and there. Even Dr. Malkiel admits this – which is why it’s called a hypothesis and not a law. But the point to remember here is that even though markets have anomalies they are generally efficient and to the extent markets are inefficient, we won’t be the ones to beat them.

Think of it this way: if hundreds of Wall Street professionals and analysts can’t get it right, what makes us think we can?

So don’t try to beat the market; buy the market.

And that’s the meat and potatoes of this book.

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Taking Distributions from Your IRA In Kind

Commemorative Diploma from 1901

When you take a distribution from your IRA, whether to put the funds in a taxable account or to convert it to a Roth IRA, you have the option of taking the distribution “in kind” or in cash.

In cash means that you sell the holding in the account or simply take distribution of cash that already exists in the account. This is the most common method of taking distributions, and it is definitely the simplest way to go about receiving and dealing with a distribution.  Cash is cash, it has only one value – therefore the tax owed on the distribution, whether a complete distribution or a conversion to a Roth account.

On the other hand, if you choose to use the “in kind” option, you might just save some tax on the overall transaction.  The reason this is true is due to the fact that the amount reported on your 1099-R for the distribution is the Fair Market Value (FMV) of the distribution.

Quite often, when you have holdings in your IRA that have very limited liquidity or marketability, the actual value on any given date could be discounted quite a bit from the eventual or Net Asset Value (NAV) of the holding.

For example, if you held shares in a limited partnership (LP) that makes investments in leveraged real estate, meaning that the real estate holdings are encumbered by mortgage loans, the value of the overall holding will first be reduced by the outstanding non-recourse (mortgage) loans against the assets.  Secondly, if the property is limited in its marketability (and what property isn’t these days?) there could be a reduction in the FMV for liquidity and marketability.

Let’s say that the LP owned several properties that amounted solely to vacant real estate that is to be eventually sold to developers.  The property was purchased several years ago with the idea that developers would quickly be willing to purchase and develop the tracts, as the area was growing quickly.  Then the property values dropped off drastically and development in the area dried up completely.

When you originally purchased the shares in the LP, you invested $100,000, and your shares are encumbered by an additional loan of $100,000 – so the original NAV of your holdings is $200,000.  Now that the property values have dropped off by 40%, your holdings effectively have a value of $120,000.  When a qualified appraiser reviews and values the property in the LP, the Fair Market Value (FMV) is set at exactly 60% of the original NAV.  In addition, the loan balance against your shares is now down to $90,000.

If you decide to convert your holdings of this LP to your Roth IRA in kind, here’s how the FMV would be calculated for tax purposes:  your FMV of the overall holdings of $120,000 (60% of the NAV) minus the encumbrance loan of $90,000, for a total value of $30,000.  So this is the amount that is reported on the 1099-R for the value of your holdings being converted.

Then (hopefully), after a year or so, fortune once again smiles on your LP, and developers come a’callin’.  Now they’re willing to pay full value plus a premium of 30% on the original values of the properties – for a total of $260,000 value on your shares.  So effectively you have a property that cost you a total of $100,000 initially, is now worth $170,000 (your $260,000 minus the $90,000 loan), and you only had to pay tax on $30,000 of the value – the rest is tax free!

Granted, this is an extreme set of circumstances that uses the tax laws to your advantage, but it represents an example that, with some adjustments, could be a real world happening.  If you happen to be investing in esoteric-type investments that might have wildy-fluctuating FMVs over time, this could be a good strategy to look into.  Just make sure you have a trusted advisor on your side who is familiar with this sort of activity – you don’t want to mess this one up, as the tax and penalty downsides can be substantial.

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Using an IRA Distribution and Withholding to Reduce Estimated Taxes

A female Snow Leopard shows her teeth

A little-known fact about how withholding works for IRA distributions can work in your favor.  While withholding from a paycheck and estimated tax payments are credited as paid during the quarter actually paid, it’s different for withholding from an IRA distribution.

When you have taxes withheld from a distribution from an IRA, no matter when it occurs during the calendar year, it is treated by the IRS as having been withheld evenly through the tax year.  This means that if you had other income in the first quarter of the year, you could take care of the tax burden with a distribution from an IRA and withholding enough tax even in late December of the same year.

So – many folks find themselves in this position, especially in years when income is is not equal in each quarter, or if the tax burden was not known or misunderstood throughout the year.

This method could be used by anyone at any time, as long as you have access to your IRA funds.  For example, if you are required to take a distribution, that is, if you’re over age 70½ or you have an inherited IRA, you could use that distribution to cover your tax burden for the entire year (if it was enough).

Rather than making quarterly estimated tax payments throughout the year, toward the end of the year you could instruct your IRA custodian to distribute enough funds to cover the tax burden for the year (and don’t forget to include the amount of your IRA distribution in your calculation). Then you would also instruct the custodian to withhold the distribution as taxes, using form W-4P.

The one downside to this method is that if the IRA account owner dies before the distribution with withholding for the tax year (and let’s face it, this will probably happen at some point), then the estate will owe penalties for underpayment of estimated tax for that year.

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Should I Use IRA Funds or Social Security at Age 62?

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Image via Wikipedia

Folks who have retired or are preparing to retire before the Social Security Full Retirement Age (FRA) face a dilemma if they have IRA assets available.  Specifically, is it better to take an income from the IRA account during the years prior to FRA (or age 70) in order to receive a larger Social Security benefit; or should they preserve IRA assets by taking the reduced Social Security benefits at age 62?

At face value, given the nature of IRA assets, it seems like the best method would be to preserve the IRA’s tax-deferral on those assets, even though it means that your Social Security benefit will be reduced.

If you look at the taxation of Social Security benefits though, you might discover that delaying receipt of your Social Security will provide a much more tax effective income later in life.  In the tables below I’ll work through the numbers to illustrate what I’m talking about.

Example

For our example, we have an individual who has a pre-tax income requirement of $75,000 per year.  The individual has significant IRA assets available.  If he takes Social Security at age 62, he will receive $22,500 per year.  Delaying Social Security benefits to FRA would get him $30,000; waiting until age 70 would provide a benefit of $39,600 per year.  In tables below we show what the tax impact would be for using Social Security at age 62, FRA, and age 70.  In each case the required income is always $75,000.

Table 1 – taking Social Security benefit at age 62:

IRA SS Tax
62 $ 52,500 $ 22,500 $ 9,556
63 $ 52,500 $ 22,500 $ 9,556
64 $ 52,500 $ 22,500 $ 9,556
65 $ 52,500 $ 22,500 $ 9,556
66 $ 52,500 $ 22,500 $ 9,556
90 $ 52,500 $ 22,500 $ 9,556
Totals $ 1,522,500 $ 652,500 $ 277,113

Table 2 – taking Social Security benefit at age 66:

IRA SS Tax
62 $ 75,000 $ 0 $ 11,113
63 $ 75,000 $ 0 $ 11,113
64 $ 75,000 $ 0 $ 11,113
65 $ 75,000 $ 0 $ 11,113
66 $ 45,000 $ 30,000 $ 7,953
90 $ 45,000 $ 30,000 $ 7,953
Totals $ 1,425,000 $ 750,000 $ 243,263

Table 3 – taking Social Security benefit at age 70:

IRA SS Tax
62 $ 75,000 $ 0 $ 11,113
63 $ 75,000 $ 0 $ 11,113
64 $ 75,000 $ 0 $ 11,113
65 $ 75,000 $ 0 $ 11,113
66 $ 75,000 $ 0 $ 11,113
67 $ 75,000 $ 0 $ 11,113
68 $ 75,000 $ 0 $ 11,113
69 $ 75,000 $ 0 $ 11,113
70 $ 35,400 $ 39,600 $ 5,901
90 $ 35,400 $ 39,600 $ 5,901
Totals $ 1,343,400 $ 831,600 $ 212,811

The difference that you see in the tables is due to the fact that Social Security benefits are at most taxed at an 85% rate. With that in mind, the larger the portion of your required income that you can have covered by Social Security, the better.  At this income level, the rate is even less, only 85% of the amount above the $44,000 base (provisional income plus half of the Social Security benefit). This results in almost $34,000 less in taxes paid over the 29-year period illustrated by delaying to age FRA, and nearly $65,000 less in taxes by delaying to age 70.

Note: at higher income levels, this differential will be less significant, but still results in a tax savings by delaying.  It should also be noted that COLAs were not factored in, nor was inflation – these factors were eliminated to reduce complexity of the calculations.  In addition, in calculating the tax, deductions and exemptions were not included.

This is to assume that the individual has the available IRA assets to allow for the early use of the funds, although in the end result, delaying to age 70 required less of a total outlay from the IRA, by nearly $180,000, in addition to the tax savings.

Hands down, this is a very significant reason to delay receiving Social Security benefits at least to FRA, and even more reason to delay to age 70.  The only factor working against this strategy would be an early, untimely death, especially if the individual in question is not married.  In that case the IRA assets would have been used up much more quickly than necessary, and no surviving spouse is available to carry on with the Social Security survivor benefit.

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One Way to Use IRA Funds to Invest in Your Business

chip shop staff

As you know, it is against all the rules to use your IRA to invest in anything which benefits you or a related party.  This is one quick way to get your entire IRA disqualified, quite likely owing a big tax bill and penalties as well.

However – and there’s always a however in life, right? – there is one possible way that you could use funds from an IRA to invest in your own business.  It’s a bit tricky, but it is a perfectly legal, in fact encouraged, method.

Howzat?  The IRS encourages the use of IRA funds for your own business?  Not exactly.  There’s more to it than that.  The IRS encourages by preferential law the use of Employee Stock Ownership Plan (ESOP) funds to invest in your business.  An ESOP is a type of qualified retirement plan that is designed specifically to invest in the stock of the employer.

So, if you have a small business and it’s incorporated, you can adopt an ESOP and roll your IRA into the plan, then use the ESOP funds to invest in your business.  You have to make certain that the ESOP follows all the usual rules – the plan has to be primarily designed to provide retirement benefits, it must be permanent in nature, you must make substantial and recurring contributions, and the plan must not discriminate against employees.

This is definitely not for the faint of heart. Although all the statutes allow the method as legal, the IRS is well aware of the method and they don’t seem to like it much.  They’re referring to this activity as “rollovers as business startups”, or ROBS, and they are siccing their auditors on abusers of the option.  I suspect that the main reason that folks run afoul of the IRS on this is if they don’t stick with the requirements for a valid plan and abuse the privilege.

As with many of these sorts of schemes, I don’t recommend it for regular use.  It could work for special circumstances though – but you should definitely be very careful if you decide to give it a shot.  The downside could be significant and painful.

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Required Minimum Distributions (RMDs) Don’t Have to Be in Cash, But…

Kinder surprise
Image by Nerea Marta via Flickr

Here’s something that I bet you’ve never run across – when you have to begin taking Required Minimum Distributions (RMDs) from your IRA or Qualified Retirement Plan (QRP), most folks think you must take these distributions in cash.

This is not the case, you can actually take distributions of any sort, not just RMDs, from your plan (IRA or QRP) in either cash or “in kind”.  By “in kind”, this means that you can take the actual securities (stocks, bonds, or other investments) from the account.  These distributions in kind can be used to satisfy your RMD for the year.  There can be both pros and cons to taking distributions in kind.

Pros in favor of in-kind distributions

You might want to consider using an in-kind distribution if your IRA or QRP is fully invested and you want to keep it that way.  Sometimes (such as in a market downturn) it can be beneficial to maintain a cash position, but generally it’s often in your best interest to remain fully invested.  Using an in-kind distribution will allow you to remain fully invested before and after your distribution.

Another reason that you might want to use an in-kind distribution is if you have a particular position in a stock (for example) that you consider to be undervalued, such that it will appreciate considerably after you’ve distributed it.  This would put you in a position to have your gain (beginning with the date of distribution) taxed at capital gains rates rather than ordinary income tax rates.

In this second case you need to understand that you’d be taxed at ordinary income tax rates on the value of the distribution (on the day of the distribution) and your basis in the position will be set at that value.  Future gains will be considered against that basis.

In addition, if you don’t have to cash out of a position in order to distribute it, you wouldn’t incur a trade commission.  Assuming that you would just re-invest in the same or a similar security, you’d then incur another trade commission when you made the new purchase.  So distributing in-kind can cause a double commission to be paid, which may not be necessary.

Cons against in-kind distributions

Sometimes it can be difficult to value a security – for example if it is very thinly-traded.  In a situation such as this, distributing the RMD in-kind can cause difficulties, especially if you’re hoping to minimize the distribution to only the required minimum.

With this in mind, in order to reduce confusion and ensure that you’re taking exactly the correct amount in your RMD, it can be prudent to maintain or create a cash holding that will be sufficient for your RMD.

Taxation

It’s important to keep in mind that no matter how you take your distributions, you’ll have to pay ordinary income tax on the distribution – and the tax may be pro-rata if the IRA is partly non-deductible.

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