In a recent television commercial, a man is shown enjoying his office retirement party at the end of which he is asked to say a few words to his friends and soon-to-be-former co­workers. “You know what I’m gonna do now?” he gleefully asks. “I’m gonna cash in my 401(k), and my wife and I are taking a trip around the world—first class all the way!” The cheers he is expecting from the crowd are not forthcoming. Instead, his announcement is met with silence and he watches, dumbfounded, while co-workers stare at him shak­ing their heads in a manner that clearly suggests that his plan may not be well thought out—at the least. Over the next few years, approximately seventy-seven million baby boomers will be faced with deciding what to do with their 401(k) and other plans savings. Loosely translated, that means over $3 trillion moving through the various finan­cial systems! Each company has different rules regarding their plans and it is best to consult with the administrator about the options available to you. Perhaps you love the plan and would like to keep your assets with the company. Will they let you? The company may have an option to receive lifetime pension income that may appeal to you. Will this income rise with inflation? Will your spouse receive income and at the same rate? Although the options your company may offer may be appealing, the fact that the choices available may be limited beg you to check outside investment options. As a rule, your best bet at retirement is a direct rollover of your company-sponsored plan assets into a traditional IRA. A direct rollover, i.e., transferring the balance, untouched and in one lump sum, to an IRA allows you to avoid current taxes and penalties. It also gives you access to more investment choices because IRAs allow you to buy individual investments such as CDs, bonds and stocks as well as mutual funds that may not available in standard company retirement plans. The additional investment choices may help you to increase your income and reduce risk. There are some pitfalls and potential problems in the rollover process. Yet a surprisingly small percentage of peo­ple, particularly those in higher income brackets, plan to engage the services of a financial planner when they get ready to rollover their plans assets at retirement. If you are among those who will not be consulting a financial planner to guide you in the rollover process, here are some tips on how to avoid costly mistakes. (Warning: “My dog ate the paperwork” is generally not accepted by the IRS as an excuse.)

Do your homework.

Tax rules governing IRAs, Roth IRAs, etc., are complicated and vary depending on what type of account you have or wish to open. These rules do change so don’t assume you know. · Know the applicable deadlines. You have sixty days to move (rollover) funds from one tax-deferred account to another. Many people miss this deadline. Perhaps they sent the paperwork to the bank with instructions to “put this money into an IRA” but failed to follow up to be sure the rollover was actually completed. Per­haps you made a clerical error in filling out the nec­essary forms, and no one catches the error until after the sixty-day deadline has passed.·

Make copies of all paperwork, checks, and applica­tions. Then send the original documents registered or overnight mail so that if there is a dispute, you will have records that the deposit and information was sent to the receiving firm in a timely manner.·

Make sure the company you are rolling your assets to is one you are familiar with and plan to invest through. It makes for a smoother transition.

To roll or not to roll must be well thought out prior to execution. Mistakes can be costly and may seriously alter your retirement expectations. Be careful and get help if you need it.

Suppose your 401(k) retirement plan includes publicly traded company stock? You can save a great deal by paying taxes on that stock now rather than later when you take a dis­tribution. A little known IRS regulation called net unrealized appreciation (NUA) allows you to pull out some (or all) of the shares in the company and separately roll the rest of your account balance over into an IRA. Any increase in the price of the stock (after you have withdrawn your shares and held them for one year) is subject only to long-term capital gains tax, which can be considerably less than ordinary income tax.Put another way, you pay ordinary income taxes on reg­ular IRA distributions assuming you have not yet paid taxes on contributions to the account. Normally, company stock rolled into an IRA is treated the same way. However, if instead of rolling company stock into an IRA, you withdraw the company stock from your 401(k) and transfer it to a tax­able brokerage account; you bypass ordinary income taxes on the NUA of the stock. What exactly is NUA? It is the differ­ence between the value of the company stock at the time it was purchased and put into your 401(k) and the value at the time of distribution, i.e., when it is moved out of your 401(k). Thus, your income tax, in this case, is based on the value of the stock when you first acquired it—not on the current (and presumably much higher) value.Another advantage of the NUA tax break with regard to company stock rollover is that there is no required minimum distribution (RMD) on those assets since they are no longer a part of an IRA.For example, if you own one thousand shares of a com­pany stock with a current value of $100,000 with a cost basis of $25,000, you would have an NUA of $75,000. Should you liquidate the stock and withdraw it, or roll it to an IRA for eventual withdrawal, the entire amount would be subject to ordinary income tax.

Assuming you are in the 30 percent tax bracket, you would owe $30,000 on the $100,000 distribution if taken in a single year.Should you choose to adopt the NUA strategy, however, your tax bill should be much less. If you were to roll the stock, in its entirety, out of your retirement plan all at once into a personal non-IRA account, your current tax liability only lies with the amount you originally invested, i.e., the $25,000. Again, if you are in the 30 percent tax bracket, the current tax due would be only $7,500 ($25,000 x .30). The remaining portion, the $75,000 net unrealized appreciation, is not taxed until you liquidate it. If you hold it for more than one year, it will be taxed at the long-term capital gains rate of 15 percent. Assuming it was sold at current market value, an additional tax of $11,250 ($75,000 x 15 percent) will be due.The tax on the $25,000 of $7,500 together with $11,250 tax equals $19,750 in total taxes. Thus, you save $10,250 by simply doing your paperwork. Not a bad way to start your retirement, don’t you think?Yes, this is a complicated concept and process. By learn­ing about it (and getting help from a financial advisor or accountant), you are likely to save a tremendous amount.

The fact is, in the circumstances described, you cannot afford not to take advantage of the NUA.Caveats: This is a one-time opportunity only. So before proceeding, be certain that the parties involved understand what you are doing. If, for example, your company handles the transfer incorrectly, that could spell trouble. Also, be sure to complete both transactions—withdrawing the stock and rollover to an IRA—in the same year. Otherwise, the IRS could deny you the tax break.Do not—I repeat, DO NOT—attempt to handle this type of transaction on your own. As a rule of thumb, all company stock and option transactions should be handled through a financial advisor. The dollar amounts associated with these transactions are typically large, which means that any mis­takes can be quite costly. Please consult your accountant, HR person, or financial professional for some guidance before you do anything.

• Ability of retirement plan participants to sue broadened: In the case of LaRue v. DeWolff, the U.S. Supreme Court unanimously held that participants in 401(k)s and other defined contribution plans can sue for investment losses incurred in their individual accounts as a result of a fiduciary’s breach of duty. Mr. LaRue sued his former employer for investment losses that resulted from an alleged failure to respond appropriately to requests for investment changes. A prior Supreme Court decision (Russell v. Mass Mutual) seemed to state that a claim for losses due to a fiduciary breach could be brought only for the plan as a whole, and not by individual participants for losses in their own accounts. In LaRue, however, the Supreme Court limited its prior decision in Russell to defined benefit plans, explaining that the Russell decision did not apply to individual account plans like 401(k) plans, which dominate the retirement landscape today. The case is likely to generate a significant increase in 401(k) plan litigation.
• Economic stimulus payment notices to be issued: Beginning this week, the IRS will begin issuing letters to 130 million households reminding them to file a 2007 federal income tax return in order to receive a 2008 economic stimulus payment. These letters are being sent to taxpayers who filed 2006 federal income tax returns. Later this month, special notices will be issued to certain recipients of Social Security and Veterans Affairs benefits, who may not ordinarily be required to file a 2007 return, but who will have to do so to obtain the stimulus payment. Despite the media coverage of the Stimulus Act and the resulting checks, there’s still quite a bit of confusion out there–expect clients to have questions (about their parents’ checks as well as their own).
• SSA says no need for recipients to request replacement 1099s: The Social Security Administration has announced that Social Security beneficiaries who are filing a 2007 federal income tax return only to obtain a 2008 economic stimulus payment do not need to request (and wait for) replacement Form 1099s. An estimate of Social Security benefits received in 2007 is sufficient.
• 529 plans–IRS waves caution flag: In an advance notice of proposed rulemaking (Announcement 2008-17), the IRS invites comments relating to rules it intends to propose to curb perceived abuses relating to 529 plans. The IRS notes that the 529 plan beneficiary rules have the potential to be manipulated to circumvent transfer tax (e.g., multiple accounts could be established with different designated beneficiaries, with the beneficiary designations later changed to a single, common designated beneficiary). The IRS also notes the possibility that an individual might attempt to avoid gift tax by contributing to a 529 account for him or herself, and then subsequently changing the designated beneficiary to a family member in the same or higher generation. To protect against these–and other–potential abuses, the IRS intends to propose anti-abuse rules that would deny favorable tax treatment when a 529 plan is used for other than its intended purpose: providing for the qualified higher education expenses of the designated beneficiary.

As of January 1, 2008, employees participating in a 401(k) or other qualified plan, 403(b) plan, or governmental 457(b) plan can roll over eligible non-Roth distributions into a Roth IRA, thanks to the Pension Protection Act of 2006 (PPA). Prior to the Act, this could only be accomplished in two steps–by first rolling the distribution over into a traditional IRA, and then converting the traditional IRA to a Roth IRA.

In Notice 2008-30, the IRS has issued guidance on these rollovers. The following are the key provisions of the Notice:

• Rollovers can be either direct rollovers or 60-day rollovers.
• Participants must include in income any amount that would have been taxable if the distribution were not rolled over.
• For taxable years beginning before January 1, 2010, a rollover is not allowed if the taxpayer has modified adjusted gross income (either individually or with a spouse) exceeding $100,000, or is married filing separately. The plan administrator is not responsible for determining whether or not a participant is eligible to make the rollover to a Roth IRA.
• The 10% early distribution tax will not apply to the rollover, However, as with conversions of traditional IRAs to Roth IRAs, if the participant takes a premature distribution from the Roth IRA within five years of the rollover, the 10% penalty will generally apply to the distribution (to the extent the distribution consists of funds that were taxed at the time of the rollover). The usual exceptions to the 10% penalty apply.
• Plans must allow participants to elect a direct rollover to a Roth IRA.
• If a participant elects to make a direct rollover to a Roth IRA, mandatory 20% withholding will not be required even though all or part of the distribution may be included in the participant’s gross income. (However, the participant and plan can agree on voluntary withholding.)
• Plan beneficiaries can directly roll over distributions to a Roth IRA, but only if the plan allows. The beneficiary’s modified adjusted gross income and filing status determine whether the beneficiary is eligible to make the rollover.

Note: Rollovers from Roth 401(k) and Roth 403(b) accounts to Roth IRAs were permitted prior to the PPA, and are subject to different rules.

Notice 2008-30 also provides guidance on several other provisions of the PPA, including qualified optional survivor annuities, and the calculation of pension plan present values using the PPA’s new definitions of “applicable interest rate” and “applicable mortality table.”

What is it?When the account owner of a traditional individual retirement account (IRA) or employer-sponsored retirement plan dies, the remaining funds in the account pass to the named beneficiary (or beneficiaries). Unlike many other inherited assets, these IRA or plan funds typically pass directly to the beneficiary without having to go through probate. (Probate is the court-supervised process of administering a will and proving it to be valid.)

These funds are usually subject to federal income tax, unlike some other inherited assets. For federal income tax purposes, post-death distributions from an IRA or plan account are treated the same as distributions that the account owner took during his or her lifetime (state income tax may also apply). In both cases, the portion of a distribution that represents pretax or tax-deductible contributions and investment earnings is taxed, while the portion that represents after-tax or nondeductible contributions is not. The difference, of course, is that the beneficiary is the one who must pay the taxes after the account owner has died. For more information, see Income in Respect of a Decedent.

If you are an IRA or plan beneficiary, you might want to leave inherited funds in the account as long as you like. This would allow you to postpone taxable distributions indefinitely, while maximizing the tax-deferred growth potential of the funds. Unfortunately, you are not allowed to do this. You will generally be required to take distributions of the inherited funds at some point, possibly sooner than you would like. However, you may have more than one option for taking distributions, and the option you choose can be critical.

Caution: While the same general rules apply to inherited Roth IRAs, Roth IRAs are unique in that qualified distributions are free from federal income tax.

Caution: This discussion focuses on the general rules regarding options available to a beneficiary that inherits an IRA or employer-sponsored retirement plan. Your IRA or plan may specify the option(s) available to you.

Beneficiary designations
Primary, secondary, and final beneficiariesPrimary beneficiaries are the IRA owner’s or plan participant’s first choices to receive the funds. By contrast, secondary beneficiaries (also known as contingent beneficiaries) receive the funds only in the event that all of the primary beneficiaries die or disclaim (i.e., refuse to accept) the funds.
Designated beneficiariesDesignated beneficiaries get preferential income tax treatment after your death. Being named as a primary beneficiary is not necessarily the same as being a designated beneficiary. Designated beneficiaries are individuals (human beings) who (1) are named as beneficiaries in the IRA or plan documents, (2) do not share the same IRA or plan account with another beneficiary who is not an individual, and (3) are still beneficiaries as of the final beneficiary determination date (September 30 of the year following the year of the IRA owner’s or plan participant’s death–the “September 30 next-year date”). The distinction is important because designated beneficiaries generally have greater and more flexible post-death options.

Tip: Are you a designated beneficiary? The answer depends on who the beneficiaries are on the “September 30 next-year date”–not who the beneficiaries are on the date of death. If you inherited an IRA or plan because the owner or participant named you as sole primary beneficiary, you are almost certainly a designated beneficiary. If you are one of several primary beneficiaries for the same IRA or plan account, you are probably a designated beneficiary if all of the other primary beneficiaries are individuals. However, if any of the other primary beneficiaries are nonindividuals (a charity, for example), you may not be a designated beneficiary. Also, if the IRA or plan funds are coming to you through the owner’s or participant’s estate, you are probably not a designated beneficiary. If the funds are coming to you from a trust that is receiving the IRA or plan dollars, special rules will apply. Consult a tax or estate planning professional.

Final date for determining beneficiariesOnly beneficiaries remaining on September 30 of the year following the year of the IRA owner’s or plan participant’s death are considered as possible designated beneficiaries for purposes of post-death distributions from the IRA or plan account.

The September 30 next-year date does two things. First, it allows the IRA owner or plan participant to change beneficiaries any time during his or her lifetime. Second, it creates the opportunity for post-death planning. For example, if an IRA owner dies and the primary beneficiary does not need the money, the primary beneficiary could make a disclaimer up until the September 30 next-year date (note, however, that to be valid for estate and gift tax purposes, a qualified disclaimer–refusal to accept benefits–must be signed by a beneficiary and meet other requirements no later than nine months after a death. Therefore, even though designated beneficiaries are determined on September 30 of the year following the year of a death, a disclaimer may need to be signed much earlier to meet the nine-months-after-death rule). This might allow the funds to pass to a secondary beneficiary with a greater financial need.

Another possibility is that one or more primary beneficiaries could “cash out” their entire share of the inherited funds by the September 30 next-year date. If this is done by the September 30 next-year date, the “cashed out” beneficiaries are not considered as possible designated beneficiaries for purposes of calculating post-death distribution methods. For example, this strategy can be very effective in cases where the primary beneficiaries include both individuals and one or more charities. The charity (ineligible as a designated beneficiary) can take its entire share (income tax free) by the September 30 next-year date, leaving only the individuals as remaining beneficiaries who may qualify as designated beneficiaries.

Caution: 2002 final regulations clarify that a designated beneficiary who dies after the death of the IRA owner or plan participant, but prior to the September 30 next-year determination date, is still treated as a designated beneficiary for purposes of calculating post-death distributions from the IRA or plan account. As discussed above, this is in contrast to situations where a designated beneficiary makes a qualified disclaimer prior to the September 30 next-year date.

Factors that determine post-death distribution optionsFirst, if you have inherited an employer-sponsored retirement plan account, the plan is generally allowed to specify the post-death distribution options available to you. These options may not be as flexible as the options permitted under the final IRS distribution rules. For example, depending on whether a plan participant died before or after his or her required beginning date, some plans may provide a different default payout method than the IRS rules. In such a case, you may not be able to elect another payout method as an alternative to the plan’s default method. Your first step should be to consult the retirement plan administrator regarding your post-death options as a beneficiary.

The other factor that determines post-death options is the type of beneficiary. Individual beneficiaries generally have more options and flexibility than nonindividual beneficiaries. For example, post-death options are severely limited if the IRA owner or plan participant dies with his or her estate as a beneficiary. This could occur if the estate is named as a beneficiary, or if there are no named beneficiaries (in which case the estate becomes the “default” beneficiary). The same limited options apply when one or more charities are named as beneficiary. Special rules apply when a trust is named as beneficiary. Under certain conditions, the underlying trust beneficiaries can be treated as the IRA or plan beneficiaries for distribution purposes.

For individuals who qualify as designated beneficiaries, the options available further depend on whether the beneficiary is a spouse or another individual. Depending on plan provisions and other factors, nonspousal individuals will typically have several post-death options. These options generally include using the life expectancy method, receiving a lump-sum distribution, taking distributions under the five-year rule, or disclaiming the funds. (See below for a description of each.) The life expectancy method is usually the default payout method, and often the most favorable method in terms of providing the longest possible payout period (thereby spreading out income taxes and maximizing tax-deferred growth).

A surviving spouse generally has all of the options available to other designated beneficiaries, plus two additional options. A surviving spouse beneficiary can elect to roll over inherited funds to his or her own IRA or plan account, providing income tax and estate planning benefits. A surviving spouse who is the sole beneficiary may also elect to leave the funds in an inherited IRA and treat that IRA as his or her own account. (This option does not apply to inherited retirement plans.) In most cases, it will be in a surviving spouse’s best interest to exercise one of the two additional options.

Tip: Nonspouse beneficiaries can not roll over inherited funds to their own IRA or plan. However, the Pension Protection Act of 2006 lets a nonspouse beneficiary make a direct rollover of certain death benefits from an employer-sponsored retirement plan to an inherited IRA. (See Nonspouse rollover to an inherited IRA–The Pension Protection Act of 2006, below.)

Tip: If a participant died before beginning to take required minimum distributions, a surviving spouse can generally wait until the year the participant would have reached age 70

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Posted in 401k News, Mutual Funds, investment help |

NEW YORK — Investors who reach retirement face the difficult task of estimating how long they will live — and how long their nest eggs should last.

A new type of mutual fund introduced by Boston-based Fidelity Investments and Vanguard Group of Valley Forge, Pa., seeks to make that task easier. The funds try to maintain a payout that can be sustained for many years.

Perforce, the new funds must make a tradeoff between expense and payout, one that poses risks and rewards for investors.

With millions of Baby Boomers set to retire, mutual fund companies, insurance companies and financial advisors are battling over retirement savings, estimated at $16.4 trillion at the end of 2006. Fidelity last week launched 11 Income Replacement funds and the Vanguard plans to launch three Managed Payout funds, each of which are meant to help retirees receive a regular payment while they remain invested.

Traditionally, the role of maintaining a steady income has been taken by fixed annuities. The new funds don’t have the higher expenses of annuities — but also, significantly, offer no guarantee that investors won’t outlive their assets, the heart of an annuity.

“In general, the fact that they’re launching these products is great,” said Brad Levin, a certified financial planner and president and founder of Legacy Wealth Partners in Encino, Calif. “Retirees are just not prepared for what they’re going to be facing as they go into retirement.” But he worries that investors in the funds “could make mistakes that cause them to run out of money.”

An insurance industry executive, who wished to remain anonymous — and whose industry competes with fund companies — said mutual fund companies should be applauded for trying to address sustained retirement income, but “without the presence of a guarantee” as in an annuity, “I don’t think they’ve gone far enough.”

Fidelity and others say the new funds weren’t meant to be annuity clones.

“This is just another arrow in the quiver for investors to use,” said Boyce Greer, president of fixed income and asset allocation at Fidelity Investments. “We wanted to provide an income vehicle that had very different characteristics than an annuity.”

Fidelity’s Income Replacement Funds are a series of 11 funds of funds combining an asset allocation strategy with an optional monthly payment program, which is offered at no cost. The funds carry “horizon dates” from 2016 to 2036, meaning the income stream from the funds are expected to end on those dates. The funds begin with a more aggressive asset allocation weighted toward equity funds and gradually shift to a more conservative allocation emphasizing fixed-income and short-term income funds.

Each of Vanguard’s Managed Payout funds is a fund of funds that will invest primarily in other Vanguard funds, including domestic and international stock index funds, bond and REIT index funds and inflation-protected securities and money-market instruments. The funds will also invest in commodity-linked investments and market-neutral or other “absolute-return” strategies, and are expected to sustain annual distribution rates from 3% to 7%.

The Vanguard Managed Payout Capital Preservation Fund offers an annual distribution rate of 7%, but no guarantee that the fund won’t eat into principle to make that distribution.

Dan Culloton, a senior analyst at Chicago investment-research firm Morningstar Inc. who covers Vanguard, said that while the funds don’t offer annuity-like guarantees, they offer more control over capital, he said.

Ellen Rinaldi, a principal in Vanguard Group’s investment counseling and research group, said, “many people are heading into retirement without any structure and withdrawing without any idea” what makes a sustainable income stream.

Greer of Fidelity said that if the funds came with a guarantee, they would not be able to offer the heightened liquidity — as mutual funds, they can be sold at net asset value and have no lock-up period — or low cost they currently offer.

Product Evolution Expected

Levin, the financial planner, said the new funds require that investors choose the appropriate income stream, but it’s not uncommon for investors to underestimate their lifespans. It’s generally understood that a 4% or 5% retirement account withdrawal rate is sustainable, he said, but an unsophisticated investor would likely choose an option offering 7%. “But can they really deliver that kind of payout over the long term?” Moreover, he said market volatility also puts a premium on advice to investors making these types of decisions.

Greer said Fidelity tells investors to be conservative and plan on living into the top quartile of life expectancies — age 92 for a man and 94 for a woman — and that the firm’s online tools prompt investors to do so.

Fidelity views the funds as building blocks, not necessarily as a place for an entire nest egg, and envisions several uses for the funds, Greer said. For example, an investor who wants to retire early or who wants income before he retires could time the Income Replacement stream to end when his defined-benefit plan or Social Security payments kick in, Greer said. Or because many retirees spend more in the first few years of retirement, they could use the payment stream for discretionary expenses, such as travel or sports club memberships, during that period, he said.

“My guess is that we’re going to find that they will be used in situations that we never foresaw,” said Greer.

As for the importance of an advisor, Culloton said, you could say the same for selecting mutual funds. Rinaldi of Vanguard said that while seeing an advisor is a great thing to do, there should be solutions for those who choose not to. “That’s one of the things we’re doing here.”

Morningstar’s Culloton said that these income distribution mutual funds are intriguing, yet imperfect options, that will evolve. “The whole idea is kind of a sea change in how people are thinking about their investments,” he said, with a shift from a focus solely on accumulation to a focus on whether or not investors are in a portfolio that will meet their retirement needs. “Financial institutions like Fidelity and Vanguard are going to figure out how this works, where it can be improved upon and how they can do that.”

Greer said Fidelity will take lessons from the market and apply them. “New products will be striking the balance between guarantees for life, liquidity and flexibility and cost,” he said.

Stocks outside of the U.S. are widely seen as strong long-term growers, but one group of popular mutual funds may be keeping investors too close to home.

Target-date funds are one-stop shops for 401(k) and other retirement-oriented investors, but these diversified offerings have been chastised for being too light on stocks, given their customers’ multidecade horizons. Fund companies have increased the stock position of these funds — including the international portion — but some investors still explore less of the globe than others.

Vanguard Group’s target-date funds, for example, keep 20% of their stock allocation outside of the U.S. Meanwhile, Fidelity Investments and T. Rowe Price Group (TROW) stay closer to 25%. Other firms ratchet exposure higher: Putnam Investments, for instance, is around 30% and AllianceBernstein tips the scale above 35%.

Target-date funds could be more intrepid, says Greg Carlson, a fund analyst at investment researcher Morningstar Inc. “For a longer-term perspective such as most of these funds are taking,” he said, “certainly one could justify a larger allocation to international.”

Indeed, around half of the world’s total stock-market value is outside of the U.S., but putting 50% of a portfolio abroad would stretch the comfort level of even seasoned investors. Yet studies show that allocating at least 20% of your stock investments in non-U.S. markets boosts returns and lowers overall risk.

Golden Globe

“There’s no question that there’s a significant diversification benefit to international investing,” said John Ameriks, a principal in Vanguard’s investment counseling and research group. “As a baseline, we think 20% gets you the largest part of that benefit.”

If 20% in non-U.S. stocks is good, some researchers say more is better. “If you are a long-term investor, we suggest that about 30% of your equity allocation be in international equity,” said Michele Gambera, chief economist at data firm Ibbotson Associates, a unit of Morningstar.

“The first 20% is more powerful than the next 20%,” Ameriks counters. “How far do you go? It’s a question of costs versus benefits. Our fundamental view is that over long periods of time you don’t expect to see large differences in returns between the domestic and international economies.”

Target-date funds aren’t market-timers, but international investing has been hugely profitable lately, especially with the feeble U.S. dollar enhancing results for Americans. Global markets outside of the U.S. returned 23% annualized in dollar terms over three years through September, and emerging markets returned 37%, according to index tracker MSCI. U.S.-based companies in the Standard & Poor’s 500 Index, meanwhile, gained 13%.

“These international markets draw attention and people start chasing them,” said Barry Taylor, a San Francisco-based financial advisor. “A high percentage of calls I get are about foreign stocks.”

Most of Taylor’s clients have 20% of their stock investments overseas, he said, but more experienced investors who “can stand the risk” are positioned closer to 30%. “The volatility of foreign markets is certainly greater than for U.S. markets,” he noted.

So while owning international stocks is important, planting portfolios more firmly on U.S. soil may not be a bad idea right now. S&P’s investment policy committee last month reduced the international weighting in its model stock portfolios to 20% from 25%. The decision reflects a negative view on Japan and trimmed exposure to developed markets, but is still five points above the portfolio’s benchmark, according to S&P international equity strategist Alec Young.

“We still like Europe and we really like emerging markets,” Young said. “But with the euro so strong, there’s a risk that growth will slow in Europe.”

Indeed, much of the gains from overseas markets lately have come from an exchange rate that brings U.S. investors more dollars when profits are repatriated. Moreover, large-cap U.S. stock funds are benefiting from global business trends. The big S&P 500 companies those funds typically own, for example, earn almost half of their revenues abroad.

“A lot of our U.S. mutual funds are finding opportunities overseas,” said Jonathan Shelon, co-manager with Ren Cheng of Fidelity’s target-date funds. “It’s much more difficult today to compare a U.S.-based company without considering its non-U.S. competitor.” Fidelity’s international-fund managers are also taking greater interest in emerging markets, he adds.

Untied Nations

Given such divergent opinions, it isn’t surprising that target-date funds’ international makeup also varies.

Vanguard’s funds, with a relatively low allocation to international stocks, ironically maintain a noticeable footprint in riskier developing regions. About 3% of the longer-dated portfolios are invested in its Emerging Markets Index Fund (VEIEX) and around 5% in Pacific Stock Index Fund (VPACX). Another 8%-10% is given to European Stock Index Fund (VEURX).

Fidelity’s offerings include five international products: about 4%-5% each in Europe Fund (FIEUX); Overseas Fund (FOSFX) and Diversified International Fund (FDIVX), with a smattering in Japan Fund (FJPNX) and Southeast Asia Fund (FSEAX).

At T. Rowe Price, target-date investors get non-U.S. exposure through the firm’s Overseas Stock Fund (TROSX), International Stock Fund (PRITX), and International Growth & Income Fund (TRIGX). Emerging markets exposure is being added to the target-date funds, says portfolio manager Jerome Clark. “We will do it slowly,” he said, “probably over at least a year. The current environment is a bit rich for emerging markets stocks

Don’t Be Pushed Into IRA Early-Withdrawal Schemes

It’s not a good idea to take money out of your IRA before you turn 59 1/2. It is, after all, money earmarked for retirement.

But besides the consequence of spending money that might one day pay for cruises and Medicare Part B premiums, there’s the harsh reality of Uncle Sam’s view of early distributions: In addition to taxing the withdrawal at ordinary income rates, the IRS imposes an additional 10% penalty on money IRA owners withdraw early.

Uncle Sam does make some exceptions. For instance, the IRS won’t impose the extra 10% tax when early distributions are due to death, disability and medical expenses that exceed 7.5% of income.

In addition, Uncle Sam looks kindly — no penalty — on early distributions used for qualified higher education expenses, first-time home purchases (limited to $10,000 over a lifetime) and health-insurance payments by unemployed individuals.

And Uncle Sam doesn’t impose the additional 10% tax on early IRA distributions when IRA owners withdraw money in what’s called a series of substantially equal periodic payments, or SEPPs. And it’s these SEPPs that are the topic of the day given recent developments. To wit: At least one firm is now advertising how IRA owners can buy real estate by using SEPPs, thus avoiding the hassles of having the IRA own the property.

In addition, federal regulators last month began a “sweep” of broker/dealers that focuses, according to published reports, on clients’ retirement accounts and the use of a section of the tax code allowing them to withdraw money before turning 59 1/2. The Financial Industry Regulatory Authority is focusing on “all seminars and/or other events directed at potential or early retirees, including prospects that are under 59-and-a-half years old.”

The action follows a June agreement in which Citigroup Group Global Markets will pay more than $15 million to FINRA to settle charges related to “misleading documents and inadequate disclosure in retirement seminars.” According to a release, brokers for Citigroup told BellSouth Employees “that they could afford to retire early by relying upon monthly withdrawals from their retirement savings pursuant to the provisions of Internal Revenue Code Section 72(t).”

Using charts, graphs, handouts and other documents at the seminars and meetings, the brokers’ sales presentations led the employees to expect that for 30 years, they could earn about 12% annually on their investments and withdraw about 9% annually, regulators said.

And what happened in reality was this: More than 200 BellSouth employees saw the principal in their accounts decline by a total of about $12.2 million.

FINRA, the largest nongovernmental regulator for all securities firms doing business in the U.S., was created in July through the consolidation of NASD and the member regulation, enforcement and arbitration functions of the New York Stock Exchange.

Words To The Wise

Given FINRA’s interest in SEPPs, we thought it wise to offer a word to those who fancy using and those who fancy selling people on using SEPPs to withdraw IRA money prior to age 59 1/2. First, experts generally agree that taking money out of IRA early is not an ideal retirement strategy.

“People should understand that IRA and 401(k) accounts provide powerful tax benefits, but only as long as the money remains in those accounts,” Kaye Thomas, author of soon-to-be-published “Go Roth!,” wrote in an email. “The exception for substantially equal periodic payments should be used only when it suits a particular personal need for which there is no satisfactory alternative. Using this rule to tap a retirement account earlier than necessary may avoid the 10% penalty tax, but has other effects that are often even more costly, as the owner will forgo decades of tax benefits on the money that was withdrawn.”

Barry Picker, author of “Barry Picker’s Guide to Retirement Distribution Planning,” said in an email that IRA owners also should consider whether the need for the money in the IRA is ongoing or a one-shot deal.

“Many people who need money for a specific purpose will set up a SEPP and lock themselves into a withdrawal program, rather than paying the 10% penalty,” he said. “But if the need is one shot, paying the penalty and leaving the rest of the money in the IRA actually works out better in the long run. But people hate the idea of paying the “penalty,” so they set up the SEPP. Paying the penalty is not the worst thing.”

Assuming you need or want to use the SEPP, (some taxpayers who retire early do need to use SEPPs to manage their taxable income and tax brackets), it’s worth knowing that there’s a wrong way and right way to go about this.

The IRS did issue some guidelines, officially called Revenue Ruling 2002-62, that were supposed to help IRA owners use SEPPs the right way. But one of the world’s foremost authorities on the subject, Robert Keebler of Virchow, Krause & Co. in Green Bay, Wis., refers to this guidance as a Trojan horse.

“It looked like good news, but it was really bad news,” he said. “It set up a series of traps.”

Payment Methods

What are those traps? First, you have to understand the methods used to calculate the payments and pick the one that’s right for you. According to Keebler, IRA owners can use one of three methods to calculate their periodic payments: required minimum distribution, fixed amortization or fixed annuitization method.

With the RMD method, the payment is recalculated each year and thus could vary from year to year. The upside to this method: There’s little chance the account won’t have money in it over the period the payments are supposed to be made.

There’s little difference between the other two methods; they both provide fixed payments. But some experts believe it’s easier to calculate payments under the amortization method. The big drawback is that it’s possible, due to market volatility and how the money is invested, the IRA could have little or no money in it before the payment period ends.

Of note, one can switch once and only once from the fixed method to the RMD method but not from the RMD to the fixed method.

Material Modifications

And therein lies another trap. According to Picker, the payments must continue for the greater of five years, counting from the date of the first distribution, or until age 59 1/2.

But if payments are “materially modified” prior to that point, Keebler notes that the 10% additional tax will be imposed on all pre-59 1/2 withdrawals. In addition to the 10% additional tax, an additional amount is added to reflect the interest on the penalty from the original year of withdrawal.

According to experts, the “material modification” part about SEPPs is the one that trips up a lot of people. “Once the SEPP is set up, it must be followed religiously, with no deviation,” Picker said. “That includes no transfers into or out of the IRA that the SEPP is coming from.”

According to Keebler, one way to avoid the material modification trap is to establish one IRA solely for SEPPs and one for future distributions and other contingencies.

Calculate The Right Rate

In calculating the SEPP, IRA owners have to determine which interest rate (120% of the midterm Applicable Federal Rate or AFR) and which life expectancy table (single, joint, or uniform life) to use. (One gets automatically admitted into Mensa if they can figure out which rate to use for SEPPs by the way. For those that need help, a visit online to 72t might be in order.)

So much can go wrong with setting up SEPPs that it’s no wonder that federal regulators are investigating 72(t) scams. So what’s the best advice?

Any SEPP “needs to be properly set up and properly adhered to,” Picker said. “Failure at either point renders the plan improper, which means all distributions up to age 59 1/2 will be subject to the 10% penalty, plus interest.”