Tips from Donna Gordon (May Wesban Monthly)
by Donna Gordon on August 6th, 2014

Five Reasons to Let a Sleeping 401(k) Lie   

Letting money sit tight in an old 401(k) plan is the path of least resistance, which is why many participants let their assets sit in the plans of former employers. This, of course, may be better than cashing the money out and spending it. Investors younger than 55 pay ordinary income taxes and a penalty on any premature distributions, which can diminish a 401(k) balance considerably. But there are also other reasons why staying put in a former employer's plan may be the best course of action.

1) Investors can't buy comparable investments on their own. One of the key reasons to stay put in a former employer's plan is if it offers investment options that are unavailable to smaller, individual investors. Institutional share classes of funds, which typically feature very low costs, are one such example. Another reason to leave money behind in an old 401(k) plan is to take advantage of a stable-value fund. This may be important for investors who are nearing retirement and looking to keep their portfolios steady, but not for younger employees who may not have such a great need for stability.

2) Investors may need early access to their money. Investors in 401(k) plans who have left their employers have another lever that IRA investors do not: the ability to tap their assets a touch earlier—at age 55 (Source: IRS 401(k) Resource Guide - Plan Sponsors, General Distribution Rules). To be eligible, workers must reach age 55 (or older) sometime during the year they retire. By contrast, IRA investors and 401(k) investors who retire before age 55 must wait until age 59 1/2 if they want to avoid the 10% early withdrawal penalty. Thus, for an investor closing in on that age who would like to have access to cash, staying put in the previous employer's 401(k) will make more sense than rolling the money over. However, it is a good idea to fully assess the portfolio's long-run sustainability before contemplating withdrawals at such an early age. Also note that some 401(k) plans may not allow the age 55 withdrawal option.

3) Investors could need the extra legal protections. Legal protections are another reason to consider staying put in an old 401(k). Although laws regarding creditor protections for retirement assets vary by state, company retirement plan assets generally have better protections from creditors and lawsuits than do IRA assets. Obviously, these protections will be a bigger consideration for those who have had credit or bankruptcy problems or who work in a profession where they may be sued.

4) Investors own company stock in their 401(k)s. When employees hold company stock in their 401(k) plans, staying put may offer a tax advantage versus rolling the money over. When company stock is held in a company retirement plan, stockholders pay capital gains tax on any appreciation over and above their cost basis when they sell the shares to take distributions in retirement (This differential is called net unrealized appreciation, or NUA). When rolling over the company stock into an IRA, on the other hand, stockholders pay ordinary income tax on the distributions they take when in retirement.

5) Investors may need the structure. Keeping the money in a 401(k) plan can provide at least a few safeguards. After all, these plans are overseen by fiduciaries who are legally required to look out for participants' interests, so the funds in the lineup tend to be well-diversified. However, investors should be aware that there may be differences in fees and expenses between 401(k) and IRA plans, and should investigate these fees and expenses carefully before making a decision.

401(k) and IRA plans are long-term retirement-savings vehicles. Withdrawal of pretax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty. Please consult with a legal, financial, or tax professional for advice specific to your situation.

Investors May ‘Prefer’ to Look Elsewhere for Yield   

With yield so scarce today, investors are branching out into different asset classes in their search for income. Many investors have set upon preferred stock, a hybrid security usually issued by highly leveraged companies, such as financial institutions, telecoms, and utilities. Preferred stock has characteristics of both bonds and stocks. Like stocks, preferreds are traded daily on an exchange. Like bonds, they pay fixed income on a regular basis (usually quarterly), but typically they do not offer as much capital appreciation potential as common stock. In the capital structure, preferred stock is senior to common stock but junior to corporate bonds, and preferred shareholders have no voting rights.

Preferred stock is not without its headwinds. In fact, there are many significant risk factors that investors must consider. Heavy exposure to financials, regulation changes, and rising interest rates are foremost on this list. Preferreds are sensitive to interest rates, but unlike bonds, they are at risk in both directions. When rates fall (presently an unlikely event), issuers often call shares to reissue at lower, more favorable rates. When rates go up, preferred stock share prices fall. Preferreds also have call options backed in, usually about five years after issuance, but some can be called even before then. Issuers can suspend dividend payments during rough periods, and in the event of bankruptcy, owners will walk away with nothing (for example, investors in preferred shares from Fannie and Freddie lost everything). In conclusion, preferred stocks' high yields may be alluring to income-seekers, but investors should approach this space with caution.

Returns and principal invested in stocks are not guaranteed, and stocks have been more volatile than other asset classes.

Mutual Fund Tax Bills Are Rising   

Mutual fund investors' tax bills have been on the rise again recently. The average capital gains distribution (a payment to shareholders of profits realized on the sale of a fund’s securities) for U.S. equity funds based on data as of April 2014 is 19.3% of assets, compared with, for example, 6.9% back in 2007. These recent distributions are among the largest seen since the start of the financial crisis in 2008.

The reason for those payouts is of course a good thing. The payouts mean that funds have produced solid returns for a few years running. The distributions were small in 2008, 2009, and 2010 because capital gains were offset by realized losses during the financial crisis. However, most of those losses are long gone.

Mutual funds are required to distribute their capital gains once a year. All of the realized gains are tallied while the realized losses and loss carry forwards from the previous year are subtracted to arrive at the total sum to be paid out. The distributions are made in equal proportions to all shareholders regardless of when they bought the fund. Then all the fund holders who own the fund in a taxable account have to pay taxes on those distributions—even if they reinvest their distribution.

What does all of this mean? Well, mutual fund investors should consider strategies for dealing with future payments. Most funds may still be sitting on sizable gains, so it's quite likely that payouts will continue to grow as funds sell their winners. Thus, fund tax bills can be expected to grow. That's a bad thing, because you'll have more money at the end of the day if you can postpone paying capital gains as far into the future as possible. The reasons are twofold: First, the time value of money means that money in today's dollars is worth more than in the future because inflation will have eroded its value. In addition, if you hold on to the money, it can compound over time in your fund, thus earning you more money.

Here, then, are a few things you can do to limit your tax bill.

1) Max out on tax-sheltered accounts. Taxable distributions are not a problem for 401(k)s, 403(b)s, and IRAs, so invest as much as the law will allow before you put money in taxable accounts.

2) Consider tax-managed funds for your taxable accounts. Tax-managed funds do a great job of avoiding making distributions because they realize losses on some holdings when they have to realize gains on others. After taxes are figured in, these funds generally put up superior returns.

3) Consider exchange-traded funds (ETFs). They don't have all the strategies available as tax-managed funds, but they do have some unique features that help reduce their tax bills. Just make sure you've chosen one that is diversified, has low costs, and has low turnover.

4) Don't buy funds that have had huge returns over the past three years. Buy a fund with huge gains and you're going to get a huge tax bill regardless of whether you make any money yourself. So, tread carefully in hot areas. If you have your heart set on such a fund, at least put it in an IRA or 401(k).

Investors should read the prospectus and carefully consider a fund’s investment objectives, risks, fees, and expenses before investing. It is important to note that ETFs are not immune from capital gains distributions; ETFs may make capital gains distributions if changes in the underlying index occur. 401(k) and IRA plans are long-term retirement-savings vehicles. Withdrawal of pretax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty. Please consult with a legal, financial, or tax professional for advice specific to your situation.

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