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Market Returns Aren’t Savings

Golden Egg

In 2013 the market and those invested in it experienced a nice return on their investments. The S&P 500 rose an amazing 29.6% while the Dow rose 26.5%. Needless to say 2013 was an amazing year for investors – but try not to make the following mistake:

Don’t confuse investment returns with savings.

While it is true that the more of a return an investor receives on his or her investments the less they have to save it still does not mean that your returns should take the place of systematic saving for retirement, college or the proverbial rainy day. And by no means should you reduce the amount you’re saving thinking that the returns from 2013 and other bull years will repeat and continue their upward bounty.

Investment returns are the returns that an investor receives in a particular time frame. For 2013, if an investor was invested in the S&P 500 or an S&P 500 index fund they received almost 30% returns for the year. Not bad. But this is deceiving. Not to burst anyone’s bubble, but we are only looking at one year. If an investor was saving for retirement for over 30 years, to expect 30% returns each year for 30 years is  like expecting my chickens to lay golden eggs – it ain’t gonna happen!

But what if an investor stops systematically saving, thinking that a 30% increase in their portfolio for 2013 can offset any additional money they intended to put in? The result would be disastrous to their retirement plan. Perhaps some numbers can help explain.

Let’s assume that we have two investors, Alex and Neil. Both are age 30, both will retire at age 65 and both start with $10,000 in their IRAs at the beginning of 2013 and both are invested 100% in the S&P 500. At the end of 2013, both investors have $13,000 in their IRAs. Up until the end of 2013, both Alex and Neil had systematically contributed the maximum to their IRAs annually – about $5,000 annually. Now they can contribute $5,500 annually.

Alex decides that since 2013 rocked, he will not contribute to his IRA for 2014 thinking that 2013’s numbers will last forever. Neil decides to keep drumming away and putting in his annual amount ($5,500 for 2014) at a steady rhythm.

Neil is handsomely rewarded for his commitment and over the next 35 years, at a 6% average annual return he amasses close to $690,000 ($698,752 for those of you with your financial calculators).

Alex is sporadic. After up years in the market he doesn’t invest and after down years he thinks he needs to contribute. It turns out that there were 20 years of downs and 15 years of ups – so Alex invested his annual IRA maximum 20 times, instead of Neil’s 35.

Keeping the math simple, let’s say that the market was down for the next 20 years causing Alex to save and then up the last 15 years causing him to relax his savings commitment. In 20 years, since there were no gains Alex has $123,000 (we assume no losses in this down market).

In the next 15 years, Alex averages 6% return and contributes nothing since they are up years. At the end of 35 years Alex has roughly $295,000 ($294,777 for those of you still calculating) – or about $400,000 less than Neil.

Admittedly my examples are very simplistic and a bit unrealistic. But the point is to not confuse your investment returns with savings. They are not the same. An investor still needs to stick to their savings plan regardless of what the market does.

In up years and I would argue more importantly in down years you need to stick to your plan of saving regularly – along with the ups and downs to take advantage of compounding returns and  buying less when the market is overpriced and more when it’s under-priced.

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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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Determining Your MAGI

Magi by Brian Whelan

There are income limits for contributing to an IRA (traditional and Roth), and below are links by filing status to illustrate the income limits in the situation where you are or are not covered by an employer-provided retirement plan, given your filing status.  This, along with your filing status and your Modified Adjusted Gross Income (MAGI) is an important factor in setting the limits for TIRAs, as there is the issue of deductibility at stake.

In order to fully understand the limitations, you also need to understand what makes up your Modified AGI (MAGI).  The MAGI is calculated as follows:

1.    Start with your Adjusted Gross Income (line 22, Form 1040A, or line 38, Form 1040).
2.    Add back in your IRA deduction amount (line 17 on Form 1040A or line 32 on Form 1040)
3.    Add back in your student loan interest (line 18 on Form 1040A or line 33 on Form 1040)
4.    Add back in any tuition and fees deductions from line 34 on Form 1040 (or line 19 on Form 1040A)
5.    Add any domestic production activities from line 35 on Form 1040 (there is no line for this on 1040A)
6.    Add back any foreign earned income exclusions from line 18 of Form 2555EZ or line 45 of Form 2555.
7.    Add back any foreign housing deduction from line 50 of Form 2555
8.    Add back any excluded qualified savings bond interest shown on line 3, Schedule 1, Form 1040A, or line 3, Schedule B, Form 1040 (from line 14, Form 8815)
9.    Add back in any excluded employer-provided adoption benefits shown on line 30, Form 8839.

The total of these nine items listed above make up your Modified Adjusted Gross Income, or MAGI.

For the IRA MAGI limitations where your income tax filing status is Single or Head of Household, click here. Note: if a taxpayer files Married Filing Separately and did not live with his or her spouse during the tax year, for the purposes of IRA eligibility that taxpayer is considered Single and would use this table. (click here for 2013 limits)

If your income tax filing status is Married Filing Jointly or Qualifying Widow(er), click here for the IRA MAGI limitations. (click here for 2013 limits)

For a tax filing status of Married Filing Separately, and you have lived with your spouse at any time during the tax year, click here for IRA MAGI limitations. (click here for 2013 limits)

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UBTI in an IRA

Erythronium hendersonii, Henderson's Fawn-Lily
Image via Wikipedia

I’ve mentioned before about various types of transactions that are not allowed in your IRA, but we’ve not actually covered the topic of Unrelated Business Taxable Income (UBTI) in your IRA.  UBTI isn’t prohibited within an IRA, but it does pose problems and adds a great deal of complexity to your account.

Unrelated Business Taxable Income

So, what is UBTI anyway?  The concept of UBTI pre-dates IRAs – it was originally developed in relation to charitable organizations, trusts, and other tax-exempt entities.  The IRS developed this concept to ensure that tax-exempt organizations didn’t have a competitive advantage over taxable organizations, such as for-profit corporations.  The way that income is determined to be “unrelated” is by checking these two tests:

  • Is the income from a trade or business that is regularly carried on?
  • Is the trade or business unrelated to the tax-exempt entity’s exercise of the entity’s tax-exempt purpose?

If these two tests are met, then the income may be UBTI.  Here’s an example that may help you to better understand the concept of UBTI (taken from IRS Publication 598:

An exempt vocational school operates a handicraft shop that sells articles made by students in their regular courses of instruction. The students are paid a percentage of the sales price. In addition, the shop sells products made by local residents who make articles at home according to the shop’s specifications. The shop manager periodically inspects the articles during their manufacture to ensure that they meet desired standards of style and quality. Although many local participants are former students of the school, any qualified person may participate in the program. The sale of articles made by students does not constitute an unrelated trade or business, but the sale of products made by local residents is an unrelated trade or business and is subject to unrelated business income tax.

The concept of UBTI covers many more situations, and you can find out much more about other types of activities that can generate UBTI by going to IRS Publication 598.


Since IRAs are, until distribution, exempt from tax, UBTI applies to certain types of income received within an IRA account as well (all of this applies to Roth IRAs as well as traditional IRAs).  The IRS Code defines any active trade or business as unrelated to the IRA’s tax-exempt purpose.

There are exceptions as well (of course there are!).  The exceptions for tax-exempt organizations are numerous and complicated.  The following is a partial list exceptions specifically for IRAs:

  • dividends
  • interest (includes “points”)
  • royalties
  • rent from real property (real estate)
  • sales proceeds from real property, as long as the property is not held as inventory or held in the normal course of a business (e.g., flipping)

This is nowhere near an exhaustive list – see Publication 598 for more details.

Examples of ways that an IRA investment could generate UBTI include: full ownership of a pass-through business, such as a limited partnership or S-Corporation; use of IRA funds to loan to a business – and the terms of the loan include participation in the profits of the business (as opposed to simple loan payments); and use of IRA funds to flip properties (via a partnership or LLC, for example), since the property is considered inventory and not investments.

Another way that UBTI is generated is through debt-financed income (also known as UDFI).  UDFI occurs in a case like this:  An IRA purchases a piece of real estate to be held for rental property.  In the purchase of the property, the IRA put 50% down in cash and financed the remaining 50% through the seller.  Even though rental income is considered to be exempt (see the list above), since debt was used to acquire the property, half of the rental income (reducing as the debt is paid off) would be considered UDFI, and therefore subject to taxation.  The good news is that the proportional part of the expenses associated with the debt-financed income would offset the income.

Okay, so my IRA has UBTI.  Now what?

If your IRA generates UBTI, it doesn’t disqualify the IRA (like prohibited transactions would).  No, what UBTI does is requires your IRA to file an income tax return.  This is unusual since an IRA is supposed to be tax-exempt, but since the UBTI is generated, income tax will be owed on the income if it reaches certain levels.

If the IRA generates gross income of $1,000 or more during the tax year, the IRA must file Form 990-T by April 15 of the following year, just like individual tax returns.  The issues that arise with this include:

  • The IRA must have a federal tax id (EIN).
  • The custodian is considered responsible for filing Form 990-T, but most self-directed IRA custodians transfer this responsibility to the account owner.
  • The IRA custodian may not have all of the information required to file the return, as much of the information in these privately-held investments is given directly to the account owner.
  • The account owner ultimately has the final responsibility to file the Form 990-T, and lack of understanding of the rules can cause major issues for the account owner.
  • The account owner also will be required to file quarterly estimated tax payments as long as the investment is in place.  Every three months, a tax payment must be made to the IRS if the total tax for the year is expected to be greater than $500.

Form 990-T is a four-page form, and filling it out can be a fairly complex undertaking – one that you’re not likely to enjoy filling out (as I’m sure you do most tax forms).

Lastly, UBTI is one of those cases where income within an IRA is actually destined to be double-taxed.  Even though you pay tax on the UBTI as it is earned within the IRA (at trust rates, not individual rates, which are more compressed), when you take the money out of the IRA you’ll be taxed again.  Paying tax on UBTI doesn’t create non-taxable basis in the IRA, in other words.

With so many other eligible investment options, why not stick with the simple, non-UBTI investments for your IRA?  If you must invest in one of these investments that could trigger UBTI if it were in an IRA, just go ahead and invest your taxable monies in the endeavor – you’ll save yourself a lot of grief.

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Required Minimum Distributions for IRAs and 401(k)s

This is one of those subjects that can be a bit confusing – and it’s based on the rules that apply to the different kinds of plans.  You are aware that you’re required* to begin taking Required Minimum Distributions (RMDs) once you reach age 70½ – but did you know that specifically which account you take the RMD from has some flexibility?  Well – not just flexibility, also some rigidity…

You Alone  amongst all  the Thousands....... m...
Image by -RejiK via Flickr

There is a Difference Between IRA and 401(k)

Starting off, we need to understand that, in the IRS’s eyes, there is a big difference between an IRA and a 401(k).  For brevity, we’re referring to all sorts of Qualified Retirement Plans, such as 403(b) or 457 plans, as 401(k) plans. You may consider the two things to be more or less equal, but if you think about it, there are considerable differences between the two – amounts you can fund the account with each year, catch-up arrangements, who can defer funds into each kind of plan, and the list goes on.

A 401(k) plan, being an employer-provided retirement plan, has a completely different set of rules governing it – including provisions that go all the way back to the original ERISA legislation.  Among those rules are the rules about RMDs.

On the other hand, the IRA is not covered by ERISA, and as such there are other rules that apply to these arrangements – including the RMDs.

We don’t have nearly enough space here to go over everything that is different between these two types of plans, but we’ll cover the RMD treatment fairly well.

Required Minimum Distributions (RMD)

Each and every 401(k) plan that you own is treated as a separate account in the eyes of the IRS.  As such, if you have four old 401(k) plans when you reach age 70½, you will have to calculate and take a separate RMD from each 401(k) plan that you have.  In other words, you couldn’t aggregate all the plans together and take one RMD from one of the accounts that is large enough to cover all the RMDs.  In addition, you have to consider each account separately and figure out how much of each RMD is taxable, if you have post-tax dollars in the account(s).

However, no matter how many IRAs that you have, since the IRS looks at these plans as one single plan, you are allowed to pool all of the account balances together, calculate the RMD amount, and then withdraw that amount any single IRA account or any combination of accounts.  Your tax basis is aggregated as well, so the tax treatment is a consideration for the entire pool of your IRAs in total (rather than account by account as is the case with 401(k) plans).


You have two old 401(k) plans and three IRAs.  This is your year, you’ve reached age 70½, so you have to start taking RMDs.  How do you do it for these five accounts?

Each 401(k) plan has to be calculated separately – and a RMD taken directly from each account.  But you can pool the IRA account balances together and take one RMD from one of the accounts that is large enough to cover all three accounts’ minimum distribution.

This is another reason why it can be helpful (from a paperwork standpoint, if nothing else) to rollover your old 401(k) plans into IRAs.  By doing this, you don’t have to take a distribution from, in the case of the example above, three different accounts at a minimum.

* One final note: if you are still working at and after age 70½ and your 401(k) plan allows it, you may not be required to take RMDs from the account.  This is yet another difference between IRAs and 401(k)s with regard to distributions.

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