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April 20, 2007

Things to Consider Before Purchasing An Investment

Before purchasing an investment for your portfolio, answer the following questions about that particular investment:

Do you know the investment’s basics? It’s not enough to know that it’s a stock or bond. You need to thoroughly understand the company behind the investment. For instance, if you are considering a stock investment, investigate the company’s business, revenue sources, competitors, historical financial performance, future prospects, historical stock price, and a host of other variables.

Will the investment fit with your current asset allocation? Your asset allocation mix should provide guidance as to what percentage of stocks, bonds, and cash to hold in your portfolio, including different categories within those broad areas. Make sure any new investments won’t throw your asset allocation mix off. If it will and you still want to purchase the investment, you may need to sell another investment to keep your asset allocation in line.

Why are you purchasing the investment? You should have clear reasons for purchasing the investment. You may even want to write those reasons down for future reference. Often, if the reasons why you purchase an investment are clear, it can help you determine when it’s time to sell.

Is this the only investment of its kind? If you are selecting a stock because you like that industry, does that stock have the best prospects? Don’t just research one specific company. Research the entire area to ensure you are selecting the appropriate investment for you.

Do you have time on your side? Consider your time horizon for investing before purchasing an investment. For instance, if you are purchasing a stock, you need to invest for the long term so you have time to overcome any short-term volatility.

Do you already own similar investments? Investors tend to purchase investments they are comfortable with, often adding similar investments to their portfolio. This does not add much in the way of diversification, while making the portfolio more difficult to monitor.

Are you comfortable with the investment? Even if you think an investment is a good one, you shouldn’t own it unless you are completely comfortable with it. If you are nervous about the risk or don’t understand it, don’t purchase the investment. There are so many investment options available now that you should be able to find ones that you are comfortable owning for the long term.

April 19, 2007

Using an IRA Distribution for Charitable Contributions

As part of the Pension Protection Act of 2006, taxpayers age 70 ½ and older can take tax-free distributions, up to $100,000 in 2006 and 2007, from traditional and Roth individual retirement accounts (IRAs) for charitable purposes. This provision is expected to increase charitable contributions from IRAs. Without this provision, donors typically find that the income tax deduction for the charitable contribution is not enough to offset the tax bill generated by the IRA distribution. With this provision, the income from the IRA is not included in gross income, and the charitable contribution cannot be deducted on the donor’s tax return.

To qualify, the distribution must meet these conditions:

• The distribution must be made from an IRA. Distributions from 401(k) plans, SEPs, and SIMPLE plans do not qualify. However, rollovers from another retirement plan to an IRA can be used for this purpose.

• Charitable contributions must be made to public charities, such as churches, hospitals, museums, and educational organizations. Contributions cannot be made to private foundations, donor advised funds, supporting organizations, or split-interest entities.

• The IRA owner must be at least age 70 ½.

• The distribution must be made directly to the charity. If the IRA owner takes the distribution and issues his/her own check to the charity, it will not qualify.

• The distribution must otherwise be fully deductible as a charitable contribution. Thus, the donor must not receive any benefit from the contribution or the entire distribution is disqualified from IRA charitable rollover treatment. The donor must obtain a written acknowledgement from the charity that no goods or services were received in return for the contribution.

• The distribution must otherwise be included in gross income. Thus, only the taxable portion of the IRA distribution qualifies. If a nontaxable distribution is taken from the IRA, the IRA owner would not have to include the distribution in income and could take a charitable contribution deduction. Qualified distributions from an IRA to charity are deemed to come first from the taxable portion of the IRA, leaving the maximum amount of tax-free dollars in the IRA.

The provision is expected to benefit taxpayers who do not itemize deductions, who want to donate more than they can currently deduct as a charitable contribution, or who find that excluding the distribution from gross income will allow them to retain other tax benefits, such as allowing a higher percentage of their medical expenses to be deducted or subjecting less of their Social Security income to income taxes.

April 13, 2007

How Much Can You Safely Withdraw from Savings

In a recent survey, respondents were asked what percentage of their retirement savings could be safely withdrawn every year without running out of money in their lifetime. Approximately 42% of the respondents did not know, 6% said 25% or more, 6% said 15% to 24%, 17% said 10% to 14%, 19% said 5% to 9%, and 10% said less than 5% (Source: National Underwriter, May 8, 2006).

While there is no one right answer, to ensure funds last for decades, it is usually recommended that no more than 4% of the balance be withdrawn each year, an answer only 10% of the respondents gave. Thus, if you need to generate $50,000 of annual retirement income in addition to Social Security and other pension benefits, you will need to save $1,250,000 by retirement age. That is a conservative number meant to ensure you never outlive your retirement funds.

That assurance, however, comes at a very steep price — many people will have difficulty saving 25 times the amount they need to withdraw annually. Thus, it is probably best to go through a detailed analysis of how much you can withdraw. This amount can be calculated based on your life expectancy, expected long-term rate of return, expected inflation rate, and how much principal you want remaining at the end of your life. Guess wrong on any of those variables and you risk depleting your assets too quickly. Yet, your life expectancy, rate of return, and inflation are difficult to predict over such a long time. Keep these points in mind when making your calculations:

Your life expectancy: While it is easy to find out your actuarial life expectancy, life expectancies are only averages. Approximately half of the population will live longer than that. You can gauge your life expectancy by how long close relatives lived and how healthy you are. Just to be safe, you might want to add five or 10 years to that age. After all, you don’t want to run out of money at age 75 or 80, when you might not be able to return to work.

Rate of return: Expected rates of return are often derived from historical rates of return and your current investment allocation. Historical rates of return are averages of returns over a period of time. Actual returns may be better than that in some years and less than that in other years. You might want to be more conservative than that, assuming a rate of return that is lower than long-term averages. Even if you get the average return right, the pattern of those returns can significantly affect your portfolio’s balance. For instance, if you experience high returns in the early years of retirement when your portfolio balance is lower and then lower returns in the later years when your portfolio balance is higher, you will have a lower ending value than if the opposite occurred.

Expected inflation: While inflation has been relatively tame recently, that has not always been the case. Inflation can have a dramatic impact on your money’s purchasing power. For instance, at 2.5% inflation, $1 is worth 78¢ after 10 years, 61¢ after 20 years, and 48¢ after 30 years. Since your retirement is likely to last decades, use an inflation estimate encompassing a long time period.

Use conservative estimates when making your withdrawal calculations. That will result in a lower withdrawal amount, but it will also help ensure that your funds don’t run out. You should review your calculations every couple of years in retirement, especially during the early years. If you find you are depleting your assets too rapidly, you may be able to go back to work on at least a part-time basis.

April 12, 2007

Organizing Your Estate for Your Heirs

Just because you have your will, trusts, and other estate planning documents in place, don’t think you are finished with the estate planning process. From your heirs’ point of view, it is just as important for you to organize your paperwork and inform them of basic decisions. One way to approach this task in a systematic manner is to prepare a notebook including the following items:

Net worth statement. An up-to-date net worth statement is a good way to ensure heirs are aware of every asset and liability. Make sure to list all pertinent information for each item on the statement, including account numbers, contact names, and phone numbers. Identify where important documents are kept, including deeds, loan agreements, insurance policies, etc. You may also want to explain your rationale for the distribution of your estate. You can go into specific detail, informing heirs how each asset will be distributed, or you can give a general overview of your estate plan. If you selected one heir as executor or trustee, explain why you chose that individual.

Individuals to contact. List names, addresses, and telephone numbers of individuals your heirs may need to contact, including employers, attorneys, accountants, insurance agents, investment managers, and financial planners.

Personal papers. Indicate where personal records are kept, including your birth certificate, marriage certificate, divorce or separation agreements, diplomas, military records, and naturalization records.

Safe deposit box. Indicate where the safe deposit box is located and what is contained in the box. Note where the key is kept and who has access to the box.

Disposition of personal items. Detail how you would like personal items distributed, including jewelry, photographs, personal collections, and furniture. Often, disputes over personal possessions are more apt to cause conflict among heirs than disputes over money, so explain your rationale for the distribution of personal items. After you have decided how to distribute your most valued possessions, come up with a method for heirs to distribute the remainder. It can be as simple as heirs taking turns to select the items they want, or flipping a coin if more than one individual is interested in the item.

Last wishes. Indicate your preferences for funeral arrangements, including whether you want a religious or secular service, whether you want flowers or donations to a charity, whether you want to donate your organs or body to medical institutions, and where you would like to be buried. These are details your heirs may feel uncomfortable asking about, but will be grateful your wishes are known so they can be carried out. Also, list any friends or family you would like contacted after your death.

Your thoughts on these subjects can change over time, so review and update the information periodically. Keep it in a place where heirs can find it immediately after your death.

April 5, 2007

Estate Plans for Married Couples

Between the unlimited marital deduction (which allows married couples to leave any amount to their spouse without paying estate taxes) and rising estate exemption amounts, many married couples may not feel much need to plan their estates. However, before reaching that conclusion, consider the following items:

Estate taxes still need to be considered. While the estate tax exemption amount is increasing (from $2,000,000 in 2007 to $3,500,000 in 2009) and the estate tax will be repealed in 2010, this amount will drop back to $1,000,000 in 2011 unless further legislation is enacted. Thus, individuals with estates over $1,000,000 still need to consider ways to use their exclusion amounts to minimize estate taxes. Those with large estates probably do not want to leave their entire estate to their spouse. While that will avoid estate taxes on the first spouse’s death, estate taxes may be owed after the second spouse’s death if the estate is larger than the estate tax exemption. While increasing estate tax exemption amounts can make it more difficult to plan, you should still consider leaving part of your estate to other heirs. If you do not want to make outright distributions in case your spouse needs the assets, you can set up a trust (commonly referred to as a credit shelter or bypass trust) to hold those assets. Your spouse can then use the income and even some of the principal, with the remaining assets distributed to your heirs after his/her death. This preserves the use of your exclusion amount.

Review whether you need a second trust. You may also want to control the remainder of your estate that is not placed in the bypass trust. Leaving the remaining assets to your spouse means he/she will control the ultimate distribution of those assets. Thus, if your spouse remarries, his/her new spouse may inherit some or all of those assets. Or, if you have children from a previous marriage, you may want to ensure those children receive a portion of your estate. Typically, a Qualified Terminable Interest Property Trust (commonly referred to as a QTIP trust) is used in those situations. Any assets not placed in the bypass trust are placed in the QTIP trust, with income distributed to your spouse during his/her lifetime. This qualifies for the unlimited marital deduction, so estate taxes will not be assessed when you die. After your spouse’s death, the principal is distributed to the heirs you designated.

Determine whether disclaimer provisions should be added to your estate planning documents. This provision details what happens if one of your heirs disclaims his/her inheritance. With the estate tax exemption amount fluctuating over the next several years, this provides a way for heirs to decide after your death how much should be placed in various trusts. This leaves a great deal of flexibility with your heirs, so the strategy should only be used if you trust their judgment.

Consider preserving your generation-skipping transfer tax amount. Leaving assets to wealthy children often means estate taxes will be paid when your children receive the assets and then again when your grandchildren receive the assets. Bequeathing the assets directly to the second or third generation can reduce estate taxes. However, the generation-skipping transfer (GST) tax, which is set at the highest estate tax rate, will apply to amounts transferred in excess of your GST exemption, which follows the estate tax exemption schedule. Again, if you do not want to make outright gifts to heirs, you can set up a trust so your spouse has access to the funds during his/her lifetime.

Check beneficiary designations and joint ownership of assets. Assets like life insurance, annuities, 401(k) plans, and individual retirement accounts will pass directly to beneficiaries, while joint assets, including bank accounts, investment accounts, and real estate, will pass directly to the joint owner. Provisions in your will and other estate planning documents cannot change those designations. Thus, review beneficiaries and joint owners to ensure that assets will transfer as you wish. Tax and estate planning considerations may make another individual a better choice. Once your spouse dies, be especially careful of joint ownership with just one of your children. While you may expect that child to share the asset with his/her siblings, that child may either not do so or may have to deal with gift tax complications.

 

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