Required Minimum Distributions (RMD) Background and Summary
On December 23, 2008, President Bush sgned into law the Worker, Retiree, and Employer Recovery Act. The Act states that no RMD is required for 2009. As you are aware, the current global economic conditions have caused sharp declines in many contract values. This Act is designed to provide relief to contract owners who would otherwise be forced to take a distribution in 2009. The goal is to not force contract owners to take a distribution when their contract value is at a low point and instead allow those funds to stay invested in the contract and participate in any economic recovery.
The RMD Rules, Briefly Stated:
Individuals are required to take at least a minimum annual distribution from their account after they reach their required beginning date, which is the April 1 after they reach age 70 1/2.
For beneficiaries of deceased individuals not already receiving RMDs, the required beginning date is either following the 5th anniversary of death (for a complete distribution) or following the 1st anniversary of death (for a periodic distribution). Special rules apply if the only designated beneficiary is the surviving spouse.
The Situation That Congress Sought to Relieve:
In the current economic environment, many contract values have been diminished by the deep declines in the stock market.
Congress was concerned that requiring individuals to take 2009 RMDs could have the unintended effect of forcing individuals to “sell low.” As a result, the RMD would diminish the likelihood of the individual being able to participate in any economic recovery.
What This Act Changes:
No RMD is required for 2009.
Any individual who attains age 70 ½ in 2009 will not be required to take a first RMD by April 1, 2010, but the distribution for the 2010 calendar year must be taken by December 31, 2010.
If the individual takes a partial withdrawal, the distribution is not subject to the mandatory 20% withholding that is typically required of RMDs.
For beneficiaries under the 5-year rule, the 5-year deferral period is extended by one year (e.g., if an individual died in 2007, the period would end in 2013 instead of 2012).
Frequently Asked Questions
Q1. If I don’t take a 2009 RMD, won’t I be required to pay a tax penalty? No. Under the Act, there is no RMD required for 2009, and no tax penalty will be assessed if you do not take your RMD. In a normal year, the Tax Code assesses a 50% excise tax on any required distribution that fails to be distributed. But 2009 will not be a normal year. No excise taxes will apply because there will be no required distributions in 2009.
Q2. I’ve been taking RMDs for years and I’ve grown to depend on them as a source of retirement income. Can I still take the distribution that I had planned on? Absolutely. Your access to your contract hasn’t changed. The only thing that’s changed is that you aren’t required to take a 2009 minimum distribution. If you would like to take a distribution anyway, you can certainly do that.
Q3. I currently have a systematic withdrawal set up on my contract. Will I still receive my
payments? A systematic withdrawal is an automatic withdrawal that you take monthly, quarterly or annually. If there is currently a systematic RMD withdrawal set up on your contract, and you wish to keep it, there is nothing you need to do. The payment you receive will be based on the RMD calculation. However, you may elect to receive a systematic withdrawal in any amount that you request.
Q3a. If I stop my payments, what will happen in 2010? Starting in 2010, your systematic payments will resume in accordance with your original instructions.
Q3b. How do I stop my payments? If you wish to stop receiving the payments, please contact us.
Q3c. Can I return a systematic payment that I received? You can roll over any payments received back into the contract. The transaction will be processed on the day that all paperwork is received in good order prior to the close of the New York Stock Exchange.
Q4. What period does the relief apply to? The relief applies to RMDs due to be paid out to satisfy the 2009 RMD requirement. Any individual who attained age 70 ½ in 2008 and opted to defer his or her 2008 payment up to April 1, 2009, would still need to take a 2008 payment between now and April 1, 2009.
Q5. Which plans does this relief apply to? The waiver applies to the following plans: IRA, 401(a), 401(k), 403(a), 403(b) and governmental 457(b) plans.
Q6. What is the relief being provided with regard to RMD payments for the 2009 calendar year?
Relief is being provided in the following ways:
a) No RMD is required for 2009.
b) Any individual who attains age 70 ½ in 2009 will not be required to take a first RMD by April 1, 2010, but the distribution for the 2010 calendar year must be taken by December 31, 2010.
c) If the individual takes a partial withdrawal, the distribution is not subject to the mandatory 20% withholding that is typically required of RMDs.
d) For beneficiaries under the 5-year rule, the 5-year deferral period is extended by one year (e.g., if an individual died in 2007, the period would end in 2013 instead of 2012).
Q7. What about the RMD I just took for 2008? Am I going to receive any relief for that?
This relief applies only to 2009.
This information is provided as general guidance. It is not intended to be legal or tax advice. Any taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor. The information source for this advisory is from ING-USA.
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Do you have old 401k plans that are “Left Behind” with old employers? Surprisingly enough, the overwhelming answer is usually yes!
One would think that 401 plans would be immune to the procrastination that we all exhibit in our lives, however even sometimes substantial sums of money fall under the category “Out of Sight, Out of Mind”.
Speaking personally, I generally try not to leave bank accounts with thousands of dollars behind when I change my checking or savings. It would be very disconcerting to have these account or accounts scattered over my former financial life, sometimes earning very little or no interest at all. Investment accounts generally do not have the same stigma though. I truly believe since you don’t make a physical deposit in many of these 401k plans, the cash or investments just don’t carry the weight of a primary checking account that enable you to put food on the table, pay your bills, and take care of your family.
Okay, you probably get my point by now. Now what are other reasons that you have not consolidated your retirement accounts?
Here are a few Old 401k Planning Excuses:
Complacency
Lack of a comprehensive roadmap to retirement
The thought that “They are doing okay where they are”
My firm belief is that you can do a much better job with most of your retirement in one self directed IRA instead of old 401k plans. Most 401k plans have limited investment options, while a self directed IRA has more of the financial buffet approach. More simply put, would you rather have only one choice, or a buffet option when choosing your next meal?
Quite frankly, when you have an IRA, you have the opportunity of investing in over 10,000 mutual funds, stocks, bonds, or even commodities. Now that is quite the variety compared to the 10 or 20 funds dictated to you in a 401k plan. That way you or your advisor can go out there and get the funds that are considered the “Allstars” in their categories. This ultimately results in better planning and better results.
Please keep in mind, you can make additional tax deductible contributions to your Self Directed or Roth IRA, while still investing in your current 401k plan
This gives you 2 pots of money that you can be adding to instead of just your current company’s plan. Be careful and weigh your options though. You do not want to start contributing to your IRA until you have exhausted the company match in your current plan.
Now you may be asking yourself……How do I go about making this change? The quick answer is that any old 401k plan or plans can be rolled over into a single self directed IRA. You can either do this yourself online with a company like TradeKing, or seek out a trusted advisor to help you in developing your retirement goals and planning. Please keep in mind though that this does not apply to your current 401k plan. You can only roll over plans from companies with which you have severed employment.
In closing, you will be better off most of the time by keeping your retirement under one umbrella, and sticking to a defined plan of attack. Take the initiative and you can help to secure your future! As always, please email us with ideas and suggestions at .
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Your Company’s 401(k) Plan, Don’t Give Up Free Money!
The term 401(k) gets thrown around so often but so many employees have no idea what the plan is or how it benefits them. A 401(k) is free money that your employer is trying to give you. All you have to do is accept. If you’re not utilizing your company-sponsored 401(k), you are really missing the boat.
Let me explain how this benefit works.
In a very cursory view, a 401(k) allows you to set aside money from each paycheck for your retirement. The true benefit though is that your employer will match what you set aside up to a certain point! In most cases, a company will match dollar-for-dollar what the employee sets aside, up to 6%.
Let’s take a look at a very simple example. For the sake of easy math, let’s say that you make $52,000 per year. You receive $1,000 a week before taxes or $2,000 every paycheck if you are paid twice a month. If you agree to set aside 6% for your 401(k), you will automatically have $120 taken from each of your paychecks. Your company will also add $120 to your account so you will end up with $240 per paycheck going toward your retirement! That is free money! Why would you not take it?
Common sense tells you that if your company is trying to give you a 6% raise, you should take it immediately but so many people do not. The reason most commonly cited is, “I just can’t afford to have 6% taken from my paycheck.”
This is no excuse. If you are using every penny of your paycheck for expenses, some work needs to be done to lower your cost of living. Are you spending too much eating at restaurants or paying too much in rent? Scale back! You cannot afford to ignore the 401(k)! In this instance, if you are living at a bare-minimum and are coming up a little short, this is the time to use your credit cards. Even if you are paying 21% in credit card interest, you’re earning an astonishing 100% return on your money through your 401(k)!
Another complaint I hear from people is, “My company is only matching up to 6%. What difference will that make?” It is absolutely huge! Let’s take a look at someone making $30,000 per year. A 6% contribute will be $1,800 per year. If you put in your part and the company adds another $1,800 to it, you’ll have a decent chunk of money when you are ready to retire! After 30 years in the 401(k), if your investment earns a modest 7%, you will have accumulated $340,058! If you earn only 1% more on your investments, you cross the $400,000 mark and end with $407,819! All of this for only giving up 6% of your check!
If you don’t think you can afford to give up the 6%, think again. Give it a shot and you will be surprised at how easy it is to contribute. You will surely get used to your checks being slightly lower than usual and your spending will adjust. Reverse your thinking, you cannot afford not to contribute!
Naturally, there is a lot more that goes into a 401(k) plan so do your research online or consult a financial adviser. Your company’s Human Resources department can also be a great resource for learning more about this benefit. The point is, when someone offers you free money, you take it.
Please visit our site for more Retirement, 401k, and Insurance information: www.erollover.com
Understanding the short- and long-term tax implications of rollovers from employer-sponsored retirement plans is a critical component of retirement planning.
That’s because while employer-sponsored retirement plans and IRAs are designed to help you to build a retirement nest egg, not understanding rollover regulations can lead to unintended tax consequences that chip away at retirement savings.
Information on this site can answer basic rollover questions such as
• When are rollovers permitted from employer-sponsored plans
• How to properly manage eligible rollover distributions
• What are the rules covering rolling one IRA to another
Also available is more detailed information including
• IRA distribution rules
• Dividends and capital gains tax rates
• Required minimum distribution regulations
Use this site to educate yourself about how you can effectively manage your rollover funds and contact your financial representative and tax accountant to talk about the IRA rollover approach that suits your financial situation.
Frequently Asked Questions
What is an IRA Rollover?
An IRA Rollover is a tax-free transfer of funds from a tax-deferred plan, such as a 401(k) plan, to a traditional IRA. An IRA Rollover occurs when an employee changes jobs and is entitled to a distribution from the old employer’s 401(k) plan. By doing an IRA Rollover, the funds can be transferred tax-free to the employee’s own IRA. This means the funds can continue to grow on a tax-deferred basis inside the IRA. It also means that the funds are under the control of the employee with respect to investment decisions and future distributions.
The term “IRA Rollover” can also be applied to a transfer of funds from one IRA to another IRA. This too can be done on tax-free basis under a different set of rules that apply to IRA-to-IRA rollovers. Those rules are covered separately.
IRA Rollovers from Employer-Sponsored Plans
When is an IRA Rollover permitted for distributions from an employer-sponsored plan?
An IRA Rollover is permitted for any “eligible rollover distribution” from an employer-sponsored plan. This includes distributions from 401(k) plans when an employee changes jobs or retires, but also includes eligible rollover distributions from other employer-sponsored plans, such a qualified pension and profit-sharing plans, defined benefit plans, 403(a) annuity plans, 403(b) annuity contracts and governmental 457 plans.
What is an “eligible rollover distribution” from an employer-sponsored plan?
Any distribution, whether all or less than all of the employee’s account, is an eligible rollover distribution, except for the following:
• Any distribution which is part of a series of substantially equal periodic payments;
• Any required minimum distributions;
• Any distribution which is made upon hardship of the employee;
• Certain returns of elective 401(k) contributions, corrective distributions, loans treated as distributions, and similar items.
When are distributions permitted to an employee from a 401(k) plan or other employer-sponsored plan?
Distributions from a 401(k) or other employer-sponsored plans are governed by IRS rules as well as the terms of the plan. In general, plan distributions require a triggering event, such as:
• Termination of employment
• Attainment of the plan’s normal retirement age
• Death
Check with the plan administrator to be sure that the employee is entitled to a distribution under IRS rules and the terms of the plan and to determine what procedures are used to request such a distribution.
How are IRA Rollovers from employer-sponsored plans accomplished?
The employee usually has a choice of two methods to accomplish the IRA Rollover - the direct rollover or the indirect rollover.
Direct Rollover
In a direct rollover, which is also sometimes called a “plan-to-plan transfer,” the eligible rollover distribution that is transferred directly by the employer-sponsored plan to the employee’s IRA. The funds are never actually transferred to the employee individually.
Indirect Rollover
Under the indirect rollover method, the employer-sponsored plan writes a distribution check to the employee, who then deposits the check in his or her own account. The employee then has 60 days to transfer all or a portion of the amount received in the distribution to an IRA. The distribution is not taxable to the employee if the transfer occurs within 60 days.
Please visit our site for more Retirement, 401k, and Insurance information: www.erollover.com
As the recession continues to plague our economy, the next shoe to drop may well be your employer match on your 401k plan. However, there are many things to think about when planning for your 401k strategy.
About 84% of companies in the U.S. offered employees a 401(k) match as of last year.
However, cash strapped companies, reducing or eliminating the retirement contribution may be one way to cut back on costs and save jobs during hard economic times.
Frontier Airlines already announced that it was suspending its matching contributions to 401(k) plans earlier this year. Struggling automakers General Motors and Ford, as well as Dollar Thrifty Automotive Group and real estate firm Cushman & Wakefield also announced they would no longer be offering employer matches.
Any well-drafted 401(k) plan allows the employer discretion to change the company’s matching policy at any time. Whether that cost saving measure will catch on has yet to be determined. Just 2% of companies reduced their employer 401(k) or 403(b) matches this year, and only an additional 4% said they plan to do so in the next 12 months.But going forward, some experts say the trend could spread as more companies look to cut costs.
Don’t stop your 401k Contributions!
For workers who do get their 401(k) match cut, that does not mean they should also stop contributing, 401k Planning experts say. Even without the contribution from your company, there is still an advantage to socking money in a 401(k), and that’s the tax savings — your contributions come with an immediate tax deduction as well as tax-deferred growth.
However, employees shouldn’t necessarily bulk up their contributions to compensate for their employer. Instead, individuals should also aim to build up some cash reserves to cover a few months to a year of living expenses in anticipation of layoffs or other financial hardship.
In addition to 401(k) contributions, investors should think about putting money in a Roth IRA. Those under the age of 50 can make a maximum annual contribution of $5,000, which is not deductible but still grows tax-free and incurs no taxes when withdrawn at retirement. To qualify for a Roth, you must not exceed certain income limits.
Ultimately, investors should be more happy to be retaining their jobs during this difficult economic period. Most employers reinstate these matches in better times, so the removal of your 401k match may just be saving your job.
Please visit our site for more Retirement, 401k, and Insurance information: www.erollover.com
Why must I take distributions from my inherited IRA?
IRAs are intended to provide for the retirement of the IRA holder and, after he or she is deceased, for the support of his or her beneficiaries. They are not intended to permanently shelter savings from income tax. For this reason, the IRS has established distribution rules to ensure that an IRA will be depleted over the course of the IRA holder’s and, if applicable, beneficiary’s life expectancies. The distributions that are taken to satisfy these rules are often referred to as required minimum distributions (RMDs).
What happens if I miss a required minimum distribution (RMD) from an inherited IRA?
Generally speaking, if an IRA beneficiary fails to take an RMD by the applicable deadline (generally December 31), the beneficiary is subject to a 50% penalty on the amount that should have been taken out, but was not. However, if a spouse beneficiary is the sole beneficiary of an inherited IRA and he or she misses an RMD, there is an added consequence. In such cases, the IRA ceases to be a beneficiary IRA and is deemed to be the surviving spouse’s own IRA.
Following the death of an IRA holder, what factors are taken into consideration for determining the distribution alternatives available for the beneficiaries of the decedent’s IRA?
While many factors can impact what distributions options are available to an IRA beneficiary following the death of an IRA holder, there are three primary factors that must be taken into consideration:
1. the age the IRA holder was at the time of his or her death
2. the beneficiary’s relationship to the deceased IRA holder
3. whether the beneficiary in question was the sole beneficiary of the IRA
How does the IRA holder’s age at death affect my distribution options as an IRA beneficiary?
Whether the IRA holder died before his or her required beginning date (April 1 following the year in which the IRA holder turned age 70½) has a major impact on what beneficiary options are available to you.
What are my distribution options as an IRA beneficiary if the IRA holder died before his or her required beginning date?
When an IRA holder dies before his or her required beginning date, two basic distribution options are generally available to you as an IRA beneficiary:
Five-Year Rule: Under this option, an IRA beneficiary can generally take distributions in any amount at any time. However, the beneficiary must totally deplete his or her portion of the IRA by no later than December 31 of the year containing the fifth anniversary of the IRA holder’s death. Life Expectancy Payments: Under this option, an IRA beneficiary must begin distributions based on his or her single life expectancy by no later than December 31 of the year following the year of the IRA holder’s death. Spouse beneficiaries, however, may wait until December 31 of the year the deceased IRA holder would have turned age 70½ to begin distributions under this rule.
(Note: The distribution options available to an IRA beneficiary following the death of an IRA holder can be significantly impacted by additional factors including the terms of the underlying IRA investments, the terms of the IRA plan agreement, and the administrative policies of the IRA trustee or custodian.)
What are my distribution options as an IRA beneficiary if the IRA holder died on or after his or her required beginning date?
When an IRA holder dies on or after his or her required beginning date, required distributions for beneficiaries, beginning in the year following the year of the IRA holder’s death, are generally determined according to the single life expectancy of the beneficiary. However, if the remaining life expectancy of the deceased holder is longer than the life expectancy of the beneficiary, the beneficiary may use the remaining life expectancy of the deceased IRA holder. For nonspouse beneficiaries (as well as spouse beneficiaries in cases where the spouse beneficiary is not the sole beneficiary) the life expectancy factor is determined according to a nonrecalculation method. On the other hand, in cases where a spouse beneficiary is the sole beneficiary, his or her life expectancy factor is determined according to a recalculation method.
When determining my required distributions as an IRA beneficiary, what does it mean to recalculate or not recalculate my life expectancy?
The federal regulations governing required IRA distributions provide two basic methods for determining life expectancy factors: recalculation and non-recalculation. With the recalculation method, an IRA holder (or spouse beneficiary) looks up a life expectancy factor for calculating required minimum distributions each year in the IRS-provided single life expectancy table found in IRS Publication 590, Individual Retirement Arrangements (IRAs). Alternatively, with the nonrecalculation method, the life expectancy factor is looked up in the life expectancy table for the first distribution year in the same way as when a person uses the recalculation method. However, in subsequent years, rather than going back to the table each year, one year is subtracted from the original life expectancy factor for each year that has passed since the first beneficiary distribution year. The life expectancy of nonspouse beneficiaries must always be determined according to the nonrecalculation method.
What beneficiary distribution options are available when a deceased IRA holder’s estate is named as the beneficiary of his or her IRA?
The distribution options available to an estate as an IRA beneficiary vary depending on whether or not the IRA holder died before his or her required beginning date. In cases where the IRA holder has died before his or her required beginning date, the IRA funds may be paid to the estate using the five-year rule (i.e., distribution may generally be made at any time in any amount provided the entire IRA is depleted by December 31 of the year containing the 5th anniversary of the IRA holder’s death). If the IRA holder died on or after his or her required beginning date, the estate may generally take distributions over the remaining (nonrecalculated) life expectancy of the deceased IRA holder.
What beneficiary distribution options are available following the death of an IRA holder when a trust is named as the beneficiary of an IRA?
If the trust meets certain criteria outlined in IRS regulations, the individual beneficiaries of the trust may be eligible for the same distributions options they would otherwise be eligible for if they had been named as direct beneficiaries of the IRA. However, in cases where the trust does not meet all of the criteria outlined in IRS regulations, the trust will either be required to take distributions in accordance with the five-year rule (if the IRA holder died before his or her required beginning date), or over the nonrecalculated life expectancy of the deceased IRA holder (if the IRA holder died on or after his or her required beginning date). In order for the individual beneficiaries of the trust to be eligible for the same distribution options they would be eligible for if they had been directly named as beneficiaries of the IRA, the trust must meet the four following criteria:
1. the trust must be valid under state law
2. the trust must be irrevocable, or become irrevocable upon the death of the IRA holder
3. the beneficiaries of the trust must be identifiable
4. a copy of the trust instrument or qualifying documentation of the trust must generally be provided to the trustee, custodian or issuer by no later than October of the year following the year of the IRA holder’s death
This information is not intended to be legal or tax advice. Please consult a tax, legal, or financial professional with questions.
Please visit our site for more Retirement, 401k, and Insurance information: www.erollover.com
I commonly get approached by individuals who are looking for advice on what their upcoming divorce means to their 401k, IRA, or other retirement plan. Divorces are tricky anyhow, but when you throw in tangible assets it opens up to a whole new dimension. Here are some brief details about what this means to your investments.
Can my IRA assets be awarded to my ex-spouse in divorce proceedings?
Yes. IRA assets can be awarded to an ex-spouse in the course of a divorce settlement.
Can IRA assets be awarded as part of a legal separation agreement?
Yes. In addition to being awarded in divorce proceedings, IRA assets may also be awarded to a spouse in the course of a legal separation.
What happens with IRA assets that are awarded to a former spouse in divorce proceedings?
Typically, IRA assets that are awarded to a former spouse in divorce proceedings are transferred to an IRA established in the name of the former spouse. This type of direct transfer is often referred to as a ‘transfer incident to divorce.’
Are IRA assets that are transferred to a former spouse typically taxed at the time of transfer?
IRA assets generally are not taxed at the time they are transferred from one spouse’s IRA to the IRA of a former spouse provided the transfer is made in accordance with a court-issued divorce decree or separation agreement.
Are IRA proceeds received in a divorce settlement exempt from the IRS 10% early withdrawal penalty that typically applies to taxable distributions taken prior to age 59½?
No, there is no special exception to the 10% early withdrawal penalty for IRA proceeds that are awarded to you as a former spouse in a divorce settlement. Once the awarded IRA assets have been transferred to an IRA in your name, you are typically subject to the normal IRA rules governing distributions, taxes and penalties.
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Everybody knows that the stock market has plunged.If you have received your quarterly statement for your 401k, 403b, IRA, or other investments, you are more than likely aghast when seeing the losses on paper. I have heard many different arguments with regards to whether this is a historic buying opportunity, or a preview of an even more severe economic downturn.
Some of the country’s most famous investors, including Warren Buffett and John Bogle, have started to make the case that it’s time to dive back into the stock market.
They are usually careful to add that they don’t know what stocks will do in the short term. Yet their basic message is clear enough: stocks are now cheap, irrational fears have been driving the market down lately, and people who buy today will be glad that they did.
Another camp is bearish due to the fact that Barack Obama has been elected, and they fear that the capital gains tax and personal income tax may dramatically increase in the near future. This can be attributed to the sell off that we are currently seeing in the markets.
But there is another argument that deserves more attention than it has gotten so far. It’s the bearish argument that is based neither on fears that the country may be sliding into another depression nor on gut-level worries about the unknown. It is based on numbers and history, and it has at least as much claim on reason as the bullish argument does.
It goes something like this: Stocks are truly cheap only relative to their values over the last 20 years, a period that will go down as one of the great bubbles in history. If you take a longer view, you see that the ratio of stock prices to corporate earnings is only slightly below its long-term average. And in past economic crises — during the 1930s and 1970s — stocks fell well below their long-run average before they turned around.
To make matters worse, corporate earnings have now started to plunge, too. Assuming that they keep dropping, stocks would also need to fall to keep the price-earnings ratio at its current level.
There are any number of ways to measure the valuation of the stock market. Some examine prices relative to earnings, others are based on cash flow, a company’s underlying assets or the total value of the market. But they tell a pretty consistent story right now. Stocks, which were fabulously expensive for much of the 1990s and this decade, no longer are.
The 10-year price-to-earnings ratio tells an incredibly consistent story over the last century. It has averaged about 16 over that time. There have been long periods when it stayed above 16 and even shot above 20, like the 1920s, 1960s and recent years. As recently as last October, when other measures suggested the market was reasonably valued, the Graham-Dodd version of the ratio was a disturbing 27. But periods in which the ratio has jumped above 20 have always been followed by steep declines and at least a decade of poor returns.
By 1932, the ratio had fallen to 6. In 1982, it was only 7. Then, of course, the market began to self-correct in the other direction, and stocks took off.
Where will we be 1, 2, or 5 years from now? I wish that I had a crystal ball, but I would say that you have to keep on buying and dollar-cost averaging in your 401k, IRA, 403b, or other retirement accounts. You may look back and be glad that you did. Hopefully, that is.
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By Mike Rowan
How Mutual Funds Work-Part 2
Today, we will continue to learn about mutual funds, and the benefits and disadvantages that they represent. Please keep in mind, all of these features of Mutual Funds can have a direct impact on the performance of your 401k, 403b, 457, IRA, or other retirement accounts. Here are the details:
What They Are
A mutual fund is a company that pools money from many investors and invests the money in stocks, bonds, short-term money-market instruments, other securities or assets, or some combination of these investments. The combined holdings the mutual fund owns are known as its portfolio. Each share represents an investor’s proportionate ownership of the fund’s holdings and the income those holdings generate.
Other Types of Investment Companies
Legally known as an “open-end company,” a mutual fund is one of three basic types of investment companies. While this brochure discusses only mutual funds, you should be aware that other pooled investment vehicles exist and may offer features that you desire. The two other basic types of investment companies are:
Closed-end funds — which, unlike mutual funds, sell a fixed number of shares at one time (in an initial public offering) that later trade on a secondary market; and
Unit Investment Trusts (UITs) — which make a one-time public offering of only a specific, fixed number of redeemable securities called “units” and which will terminate and dissolve on a date specified at the creation of the UIT.
“Exchange-traded funds” (ETFs) are a type of investment company that aims to achieve the same return as a particular market index. They can be either open-end companies or UITs. But ETFs are not considered to be, and are not permitted to call themselves, mutual funds.
Some of the traditional, distinguishing characteristics of mutual funds include the following:
Investors purchase mutual fund shares from the fund itself (or through a broker for the fund) instead of from other investors on a secondary market, such as the New York Stock Exchange or Nasdaq Stock Market.
The price that investors pay for mutual fund shares is the fund’s per share net asset value (NAV) plus any shareholder fees that the fund imposes at the time of purchase (such as sales loads).
Mutual fund shares are “redeemable,” meaning investors can sell their shares back to the fund (or to a broker acting for the fund).
Mutual funds generally create and sell new shares to accommodate new investors. In other words, they sell their shares on a continuous basis, although some funds stop selling when, for example, they become too large.
The investment portfolios of mutual funds typically are managed by separate entities known as “investment advisers” that are registered with the SEC.
Advantages and Disadvantages
Every investment has advantages and disadvantages. But it’s important to remember that features that matter to one investor may not be important to you. Whether any particular feature is an advantage for you will depend on your unique circumstances. For some investors, mutual funds provide an attractive investment choice because they generally offer the following features:
• Professional Management — Professional money managers research, select, and monitor the performance of the securities the fund purchases.
• Diversification — Diversification is an investing strategy that can be neatly summed up as “Don’t put all your eggs in one basket.” Spreading your investments across a wide range of companies and industry sectors can help lower your risk if a company or sector fails. Some investors find it easier to achieve diversification through ownership of mutual funds rather than through ownership of individual stocks or bonds.
• Affordability — Some mutual funds accommodate investors who don’t have a lot of money to invest by setting relatively low dollar amounts for initial purchases, subsequent monthly purchases, or both.
• Liquidity — Mutual fund investors can readily redeem their shares at the current NAV — plus any fees and charges assessed on redemption — at any time.
But mutual funds also have features that some investors might view as disadvantages, such as:
• Costs Despite Negative Returns — Investors must pay sales charges, annual fees, and other expenses (which we’ll discuss below) regardless of how the fund performs. And, depending on the timing of their investment, investors may also have to pay taxes on any capital gains distribution they receive — even if the fund went on to perform poorly after they bought shares.
• Lack of Control — Investors typically cannot ascertain the exact make-up of a fund’s portfolio at any given time, nor can they directly influence which securities the fund manager buys and sells or the timing of those trades.
• Price Uncertainty — With an individual stock, you can obtain real-time (or close to real-time) pricing information with relative ease by checking financial websites or by calling your broker. You can also monitor how a stock’s price changes from hour to hour — or even second to second. By contrast, with a mutual fund, the price at which you purchase or redeem shares will typically depend on the fund’s NAV, which the fund might not calculate until many hours after you’ve placed your order. In general, mutual funds must calculate their NAV at least once every business day, typically after the major U.S. exchanges close.
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Let’s face it. You are probably getting hammered in your 401k, 403b, 457 Plan, or IRA accounts, during this severe economic downturn. In my experience, many of these external market factors are simply out of the investor’s control. However, information is knowledge, so you can at least familiarize yourself with some of the jargon so that you can speak knowledgeably about your investments and retirement accounts. In this post, we will give you the basic run down on Mutual Fund terms, and the details that you need to know.
Glossary of Key Mutual Fund Terms
12b-1 Fees — fees paid by the fund out of fund assets to cover the costs of marketing and selling fund shares and sometimes to cover the costs of providing shareholder services. “Distribution fees” include fees to compensate brokers and others who sell fund shares and to pay for advertising, the printing and mailing of prospectuses to new investors, and the printing and mailing of sales literature. “Shareholder Service Fees” are fees paid to persons to respond to investor inquiries and provide investors with information about their investments.
Account Fee — a fee that some funds separately impose on investors for the maintenance of their accounts. For example, accounts below a specified dollar amount may have to pay an account fee.
Back-end Load — a sales charge (also known as a “deferred sales charge”) investors pay when they redeem (or sell) mutual fund shares, generally used by the fund to compensate brokers.
Classes — different types of shares issued by a single fund, often referred to as Class A shares, Class B shares, and so on. Each class invests in the same “pool” (or investment portfolio) of securities and has the same investment objectives and policies. But each class has different shareholder services and/or distribution arrangements with different fees and expenses and therefore different performance results.
Closed-End Fund — a type of investment company that does not continuously offer its shares for sale but instead sells a fixed number of shares at one time (in the initial public offering) which then typically trade on a secondary market, such as the New York Stock Exchange or the Nasdaq Stock Market. Legally known as a “closed-end company.”
Contingent Deferred Sales Load — a type of back-end load, the amount of which depends on the length of time the investor held his or her shares. For example, a contingent deferred sales load might be (X)% if an investor holds his or her shares for one year, (X-1)% after two years, and so on until the load reaches zero and goes away completely.
Conversion — a feature some funds offer that allows investors to automatically change from one class to another (typically with lower annual expenses) after a set period of time. The fund’s prospectus or profile will state whether a class ever converts to another class.
Deferred Sales Charge — see “back-end load” (above).
Distribution Fees — fees paid out of fund assets to cover expenses for marketing and selling fund shares, including advertising costs, compensation for brokers and others who sell fund shares, and payments for printing and mailing prospectuses to new investors and sales literature prospective investors. Sometimes referred to as “12b-1 fees.”
Exchange Fee — a fee that some funds impose on shareholders if they exchange (transfer) to another fund within the same fund group.
Exchange-Traded Funds — a type of an investment company (either an open-end company or UIT) whose objective is to achieve the same return as a particular market index. ETFs differ from traditional open-end companies and UITs, because, pursuant to SEC exemptive orders, shares issued by ETFs trade on a secondary market and are only redeemable from the fund itself in very large blocks (blocks of 50,000 shares for example).
Expense Ratio — the fund’s total annual operating expenses (including management fees, distribution (12b-1) fees, and other expenses) expressed as a percentage of average net assets.
Front-end Load — an upfront sales charge investors pay when they purchase fund shares, generally used by the fund to compensate brokers. A front-end load reduces the amount available to purchase fund shares.
Index Fund — describes a type of mutual fund or Unit Investment Trust (UIT) whose investment objective typically is to achieve the same return as a particular market index, such as the S&P 500 Composite Stock Price Index, the Russell 2000 Index, or the Wilshire 5000 Total Market Index.
Investment Adviser — generally, a person or entity who receives compensation for giving individually tailored advice to a specific person on investing in stocks, bonds, or mutual funds. Some investment advisers also manage portfolios of securities, including mutual funds.
Investment Company — a company (corporation, business trust, partnership, or limited liability company) that issues securities and is primarily engaged in the business of investing in securities. The three basic types of investment companies are mutual funds, closed-end funds, and unit investment trusts.
Load — see “Sales Charge.”
Management Fee — fee paid out of fund assets to the fund’s investment adviser or its affiliates for managing the fund’s portfolio, any other management fee payable to the fund’s investment adviser or its affiliates, and any administrative fee payable to the investment adviser that are not included in the “Other Expenses” category. A fund’s management fee appears as a category under “Annual Fund Operating Expenses” in the Fee Table.
Market Index — a measurement of the performance of a specific “basket” of stocks considered to represent a particular market or sector of the U.S. stock market or the economy. For example, the Dow Jones Industrial Average (DJIA) is an index of 30 “blue chip” U.S. stocks of industrial companies (excluding transportation and utility companies).
Mutual Fund — the common name for an open-end investment company. Like other types of investment companies, mutual funds pool money from many investors and invest the money in stocks, bonds, short
