Tips from Donna (January 2014)
by Donna Gordon on February 11th, 2014

Year-End Portfolio Review: Re-balancing

Finding the right frequency for re-balancing is a personal decision that rests on a number of factors. Here's an overview of what to bear in mind.

Tax Status of Investments: Rebalancing involves peeling back on winners, which in turn could result in taxable capital gains if the sales occur within taxable accounts. Investors whose assets are mostly in taxable accounts may want to err on the side of less-frequent rebalancing. On the flip side, the tax costs of rebalancing aren't a concern for investors who hold assets mostly in tax-sheltered accounts.

Other Costs of Trading: Commissions, for example. Investors who use a commission-based broker or buy or sell by themselves on a commission-based platform may consider rebalancing less frequently. Those who do not use a broker can view transaction costs as less of an impediment to rebalancing.

Time Commitment: A more frequent monitoring and rebalancing approach requires a greater amount of time than a laissez-faire tack. For example, retirees who have the time to commit to more frequent oversight (and won't incur tax and transaction costs to rebalance) can take a more hands-on approach. For busy investors, it’s fine to check up annually.

Time Horizon/Risk Tolerance: The key benefit of rebalancing is in the realm of risk management, not potential return enhancement. By extension, investors with shorter time horizons and more limited risk tolerance may want to tightly police their asset allocations versus their targets. Longer-term investors, meanwhile, can employ a more hands-off approach.

This information is provided for informational purposes only and should not be construed as tax advice. Consult your tax advisor for advice regarding your personal situation.

Misconceptions About Backdoor Roth IRA Conversions

In 2014, the income limit for Roth contributions is $129,000 for single filers and $191,000 for married couples filing jointly. For high-income earners who earn too much to contribute to a Roth IRA directly, the only method of getting new assets into a Roth IRA is to go in through the backdoor, opening traditional nondeductible IRAs, then converting those accounts to Roth IRAs. It's a way for higher-income folks to pay tax now in exchange for tax-free withdrawals of at least some of their assets during retirement. But the maneuver carries some important caveats, so it pays to stay attuned. Here are four of the biggest misconceptions about backdoor Roth IRAs.

Backdoor Roth IRAs Are Always Tax-Free: When you convert the newly opened traditional IRA to a Roth, you'll owe taxes on any appreciation in your shares since you made the initial purchase if you have no other IRA assets. But if you do hold other IRA assets, you'll be affected by what's called the pro rata rule. Under this rule, the IRS looks at your total IRA holdings to determine your tax bill when you do the conversion; the tax you pay depends on your ratio of assets that have already been taxed to those that have not. Let’s say you have $45,000 in a rollover IRA and $5,000 in your new nondeductible IRA. That means your ratio of taxable/tax-free assets in your total IRA is 9/1. Upon conversion of that new $5,000 traditional IRA, you'd owe taxes on $4,500 of income, because 90% of your total IRA pool consists of money that has not been taxed. You'll run into the same issue if you try to execute a backdoor IRA and you also have traditional IRA assets on which you've taken a tax deduction; ditto if you have made nondeductible contributions but a big share of your IRA balance consists of appreciation. In both cases, the pro rata rule would affect the taxes due when you convert.

A Backdoor IRA Should Always Be Off-Limits if You Have Traditional IRA Assets: The preceding example illustrates the tax treatment if you undertake a backdoor IRA and have a lot of money in a traditional or rollover IRA that has never been taxed. If you have a rollover IRA and participate in a company retirement plan that permits it, you can roll that money into the 401(k) before executing the backdoor Roth IRA. In doing so, those dollars wouldn't be part of the calculation of taxes due under the pro rata rule.

Once You Go Backdoor, You Can Readily Make Additional Roth Contributions: One other common misconception about backdoor IRAs is that once you do one, you can make additional Roth contributions. Unfortunately, this is true only if your income falls below the Roth IRA eligibility thresholds in future years, or if you no longer participate in a company retirement plan. If that's the case, you can make a Roth contribution outright. All others, however, will have to go through the same motions to make additional Roth contributions, first contributing to a traditional IRA and then converting to a Roth.

All Roth IRAs Give You Easy Access to Your Cash: Flexibility is one of the key benefits to having a Roth IRA. If you make direct contributions (that is, your entry point into a Roth isn't through converting), you can withdraw your contributions (but not your earnings) at any time without owing tax or a penalty. But if you get into a Roth IRA via conversion, you're governed by a different set of rules. To avoid the 10% penalty on early withdrawals of the amounts you've converted, you need to hold those assets in your Roth IRA for five years, you need to be age 59 1/2, or you need to meet other exceptions.

Funds in a traditional IRA grow tax-deferred and are taxed at ordinary income tax rates when withdrawn. Contributions to a Roth IRA are not tax-deductible, but funds grow tax-free, and can be withdrawn tax free if assets are held for five years. A 10% federal tax penalty may apply for withdrawals prior to age 59 1/2. Please consult with a financial or tax professional for advice specific to your situation.

529 Plan Participants Deserve Better Disclosure

College savers need to be aware of many details when choosing a 529 plan, yet often the information either isn't provided or takes too much digging to find. A recent Morningstar study of 529 plans' disclosure found that the typical 529 plan website and plan document provide only high-level descriptions of the investment options. Basic information, including the name and tenure of the portfolio managers running the 529 investment options and details about the most recent portfolios, isn't required disclosure for 529 plans.

What Investors Need to Know for Static Options: Static 529 plans are plans whose investment allocation does not change over time. Unlike the age-based options (discussed below), they do not move to a more conservative allocation mix as the beneficiary approaches college age.

For static options, crucial information includes how much the option costs, who manages the portfolio and how experienced they are, what the investment strategy is, what the portfolio owns, and what the performance record is.

For stock fund portfolios, it’s good to know whether an investment is primarily exposed to big or small companies, or firms in a specific sector of the economy, like health care, technology, or energy. This information may help investors and advisors anticipate how an investment will perform and identify potential risks. With bond portfolios, it is important to look at credit quality and interest-rate exposure to broadly understand how the plan will perform in different market environments. For example, a portfolio with low credit quality may outperform in bull markets, when investors are less risk-averse, but it could post steep losses in a downturn.

What Investors Need to Know for Age-Based Options: Age-based options hold the majority of 529 assets and have a similar structure to the popular target-date mutual funds found in retirement savings plans. Age-based options' asset allocation becomes more cautious over time, moving college savers' assets from primarily stocks when the beneficiary is young to primarily bonds and cash as college enrollment nears. For an age-based option, necessary disclosure should include how much it costs and who's managing the portfolio, but also a description of the asset allocation strategy, the strategies of the underlying holdings, and the performance record.

Morningstar's study showed that few 529 plans provide this valuable information. Professional investment researchers can dig it up by cross-referencing 529 investments with data on the plan's ultimate mutual fund holdings, but college savers would be much better served if this portfolio and manager information were easily accessible.

Transparency Matters: Better informed investors can make better investment decisions, but most 529 plans aren't providing the basics that college savers and their financial advisors need to make informed choices. Just as mutual fund investors can get access to the appropriate data to monitor and evaluate a fund, college savers deserve an equally high standard of transparency. Importantly, the data should be timely and easily accessible. Examples of good disclosure exist in both the 529 plan and mutual fund industry, so plans with poor transparency should emulate the disclosures of their peers.

529 plans are tax-deferred college savings vehicles. Any unqualified distribution of earnings will be subject to ordinary income tax and subject to a 10% federal penalty tax. Tax law is ever-changing and can be quite complex. It is highly recommended that you consult with a financial or tax professional with any tax-related questions or concerns. An investor should consider the investment objectives, risks, and charges and expenses associated with municipal fund securities before investing. More information about municipal fund securities is available in the issuer's official statement, and the official statement should be read carefully before investing.

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